In this article I want to sketch out a scenario in which, rather than analyse policy announcements or make predictions, I try to lay out what are the various possible paths open to China. The scenario concerns trade. China’s current account surplus has declined sharply from its peak of roughly 10 per cent of GDP in the 2007-2008 period to probably just under 4 per cent of GDP last year. Over the next two years the forecast is, depending on who you talk to, either that it will rise significantly, or that it will decline to zero and perhaps even run into deficit. The Ministry of Commerce has argued the latter and the World Bank the former.
I am not sure which way the surplus will go, but I would argue that either way it is going to be a very strained and difficult process for both China and the world. On the one hand if the Ministry of Commerce is arguing, as many do, that the rapid contraction in the surplus indicates that China is indeed rebalancing and will continue to do so, I think they are almost certainly wrong. China is not rebalancing and the decline in the surplus was driven wholly by external conditions. In fact until 2010, and probably also in 2011, the imbalances have gotten worse, not better.
For proof, consider China’s total savings rate as a share of GDP relative to China’s total investment rate. The current account surplus, of course, is equal to the excess of savings over investment – any excess savings must be exported, and by definition the current account surplus is exactly equal to the capital account deficit. This is the standard accounting identity to which I have referred many times.
The savings and investment numbers show that the last time investment exceeded savings was in 1993-94, and during that time China of course ran a current account deficit. This was just before Beijing sharply devalued the renminbi, after which it immediately began running a surplus, which has persisted for 17 years. Since 2007 savings have climbed from 50 per cent of GDP to nearly 53 per cent in 2010. During this time investment has climbed from just over 40 per cent of GDP to nearly 49 per cent. The difference between the two has declined from just over 10 per cent of GDP to just under 4 per cent, and this of course is just another way to say that China’s current account surplus has dropped from just over 10 per cent of GDP to just under 4 per cent.
Savings are rising
From the accounting identity it is clear that if the current account surplus declines, there are logically only two ways it can happen. One way is for the savings rate to decline. In that case the investment rate must either rise, or it must decline more slowly than the savings rate. The other way is for the savings rate to rise. In that case the investment rate must rise even faster.
In the first case a declining savings rate indicates that Chinese consumption is indeed rising and Chinese investment is declining (or at least rising more slowly than consumption). This is the 'right' way for the trade surplus to decline because it represents a rebalancing of the Chinese economy away from its dependence on investment and the trade surplus and towards consumption. In the second case – the 'wrong' way – consumption is actually declining further as a share of GDP, and the reduction in China’s dependence on the trade surplus is more than matched by an increase in its dependence on trade.
So is China rebalancing? Of course not. Rebalancing would require that the domestic consumption share of GDP rise. Is the consumption share of GDP rising? Clearly not. If consumption had increased its share of GDP since the onset of the crisis, the savings share of GDP would be declining.
And yet savings continue to rise. This is the opposite of rebalancing, and it should not come as a surprise. Beijing is trying to increase the consumption share of GDP by subsidising certain types of household consumption (white goods, cars), but since the subsidies are paid for indirectly by the household sector, the net effect is to take away with one hand what it offers with the other. This is no way to increase consumption.
Meanwhile investment continues to grow and, with it, debt continues to grow, and since the only way to manage all this debt is to continue repressing interest rates at the expense of household depositors, households have to increase their savings rates to make up the difference. So national savings continue to rise.
What then explains the decline in China’s current account surplus over the past three years? The numbers make it pretty obvious. The sharp contraction in China’s current account surplus after 2007-08 was driven by the external sector, and in order to counteract the adverse growth impact Beijing responded with a surge in investment in 2009. You can argue whether or not this was an appropriate policy response (yes because otherwise growth would have collapsed, or no because it seriously worsened the imbalances), but certainly since then as consumption has failed to lead GDP growth, investment has continued rising too quickly.
Can China’s surplus rise further?
It is, in other words, rising investment, not rebalancing towards higher consumption, that explains the contraction in the current account surplus. The savings share of GDP is still actually rising. By coincidence I recently received a piece from Louis Kuijs, formerly of the World Bank and now of the Fung Global Institute, that supports this interpretation. In it he says:
Many a headline has highlighted how rising costs in China are putting pressure on profit margins and reducing the competitiveness of the country’s huge labour-intensive, export-oriented manufacturing industry – prompting multinational companies to start shifting production to other countries in Asia.
However, a closer look at trade data shows that China’s overall exports are still gaining market share. In 2011, Chinese exports grew by around 20 per cent in US dollar terms and 10 per cent in real terms, compared to an increase in real global imports of around 7 per cent.
Kujis goes on the argue that China’s export growth will remain strong in the future, and he may be right, but for me what is important here is that while the world is struggling with weak growth in demand, and surplus countries are being forced to rein in their surpluses, China’s share of total surpluses are probably actually expanding. This suggests that China is restraining, not leading, global trade rebalancing, and given China’s difficulty in raising the consumption share of GDP this shouldn’t be a surprise.
So which way will China’s current account surplus move over the next few years? If we could ignore external conditions, I would argue that the current account surplus should grow in the next few years. Why? Because Beijing is finding it impossibly hard to raise the consumption rate, and yet it is extremely important that it reduce the investment rate before debt levels become unsustainable. Under these conditions I would argue that we should expect the savings rate to hold steady as a share of GDP or – if we are lucky – for it to decline slowly over the next few years.
Investment, on the other hand, should decline quickly unless it proves difficult for the post-transition leadership to arrive at a consensus about the need to slow investment growth. I would expect investment to begin dropping erratically sometime in 2013, but I confess that I have no sense of whether or not those who understand how dire the economic situation is can convince the others within the leadership during this period.
If investment rates drop more quickly than the savings rate, by definition this would result in an increase in China’s current account surplus. This is why I would argue that if we ignore external conditions I would predict a rise in China’s trade surplus over the next few years. But of course there is a huge constraint here. Can the world accommodate China’s need to absorb more foreign demand in order to help it through its own transition?
Here I am pretty pessimistic. The first problem is that the big deficit countries have little appetite for rising imbalances. Clearly the US wants to reduce its trade deficit and at the very least it will resist a rapid increase in the trade deficit. The deficit countries of peripheral Europe, who with the US represent the bulk of global trade deficits, are going to have to adjust quite quickly as the financial crisis continues and as their growth slows, and their deficits will contract sharply as their abilities to finance them contract.
Declining trade deficits around the world require declining trade surpluses. Part of the adjustment in Europe I suspect will be absorbed by a contraction in Germany’s surplus, but the Germans of course are resisting as much as possible since they, too, are dependent for growth on absorbing foreign demand. I don’t know how this will pan out, but certainly Europe as a whole expects its trade surplus to rise, and if instead it begins to run a large deficit, German growth will go negative and the debt burden of peripheral Europe will be harder than ever to bear.
Don’t expect Europe, in other words, easily to accommodate China’s need for a growing trade surplus. If foreign capital flows to Europe increase – perhaps as China and other BRICs lend money to Europe – Europe’s exports will certainly decline relative to imports, but because this means much slower growth for Europe, I don’t think it is sustainable.
Michael Pettis is a Senior Associate at the Carnegie Endowment for International Peace and a finance professor at Peking University’s Guanghua School of Management. He blogs at China Financial Markets.