An End to China’s Imbalances?

As early as 2005， ana- lysts and academics became concerned about the prospects for， and sustainability of， growing current account imbalances in the world’s largest economies. In the United States， low savings rates and growing household consumption， fueled in part by what later turned out to be a bubble in the property market， sucked in imports from abroad， causing the trade and current account deficit to balloon. Of course， this deficit had a counterpart among the United States’ principal trading partners. Among the oil producers， strong demand and rising prices resulted in growing trade surpluses and a rising net foreign asset position. In Germany and Japan external surpluses rose steadily throughout the 2000s mainly on account of rising trade surpluses but also， in Japan’s case， due to rapidly growing income flows accruing on Japan’s significant stock of foreign assets. Finally， in China， beginning in 2004， the trade surplus took an unprecedented turn upwards which， in turn， created significant pressure for the renminbi to strengthen.

As a by-product of the Great Recession， current account surpluses and deficits across the globe contracted. The U.S. saving rate moved sharply upwards and external demand collapsed. Japan’s current account surplus fell from 4.8 percent of GDP in 2007 to 2.8 percent of GDP in 2010. Germany’s current account surplus fell from 7.5percent of GDP to 5.75 percent of GDP over the same period. Despite relatively high oil prices， the current account surpluses of the oil exporters were cut in half.

And then there is China. In the world’s second largest economy the current account surplus was cut in half from 2007 to 2009， amounting to a US$150 billion swing in the current account surplus. The surplus leveled off in 2010 as the global economy recovered but then， last year， the current account surplus was almost cut in half once again. Forecasting China’s external accounts has always been challenging， in part reflecting rapid structural change， uncertainties surrounding China’s terms of trade， and a difficulty predicting the path for the global recovery， but the scale of this current account reversal has been far sharper and more durable than expected.

The recent path of China’s external imbalance

Up until 2004， China’s external imbalances were relatively small with the trade surplus averaging only 3 percent of GDP from 1994?2003. This was reflected at a more disaggregated level whereby the trade surplus or deficit for various product components was also very small， although the trade surplus on textiles did grow steadily during the period. Starting in 2004， the size of China’s imbalance accelerated， most notably due to an upswing in net exports of machine mechanical devices. This was offset， in part， by a significant expansion of China’s trade deficit in minerals. Despite this， as a share of GDP， China’s current account was able to rise to reach double digits by the eve of the global financial crisis and， at the time， there were few signs that the pace of growth of the imbalance was set to slow down anytime soon.

However， what happened next was an extraordinary set of global circumstances that combined to set-off the worst global financial crisis in the postwar period. Against this external backdrop， China’s current account surplus was cut in half between 2007 and 2009 and， by 2011， had fallen to 2.8 percent of GDP. This compression in the external surplus was largely a result of a falling trade balance (which went from 9 percent of GDP in 2007 to 3.3 percent of GDP in 2011).

Certainly the fall in the trade balance has a cyclical component. After all， growth and demand in the global economy was damaged by the global financial crisis and there was an expectation that balance sheet repair and ongoing de-leveraging would weigh on growth well into the medium term. At the same time， the significantly higher demand for imported minerals and energy was a side effect of China’s policy response to the global financial crisis， to put in place a significant infrastructure-driven stimulus funded by high credit growth.

Nevertheless， there have also been more lasting forces at work， affecting the trade surplus in both directions. Domestic costs are rising， the costs of imported inputs (particularly commodities) have risen， and the simulative effects on trade that were created by China’s accession to the WTO may be waning. On the other hand， the relocation of global manufacturing capacity to China (financed by significant FDI inflows) continues and capacity is being built in new industries as China moves rapidly up the quality ladder. In what follows， we aim to weigh these various competing factors first by analyzing the main forces behind the recent decline in the surplus and then by drawing things together to summarize what this all means for China’s external imbalance going forward.

What is driving the declining surplus?

Since 2008 the global environment that China faces has changed radically. It has become clear that the path the advanced economies were on during the“Great Moderation” was unsustainable and built on excessive consumption and leverage. As a result， in 2008， the level of GDP in the advanced economies took a large step down. In addition， going forward， growth is likely to struggle as balance sheet excesses are worked through. This will certainly prove to be a headwind for China’s trade performance as global demand for tradable goods remains well below the levels that would have prevailed if the pre-crisis trajectory had continued. Part of this is cyclical; eventually the output gap in advanced economies is expected to close. However， there is also a longerterm trend with the advanced economies expected to endure lower potential growth over the medium-term. Indeed， the IMF’s estimates of potential output growth in the U.S. have fallen from an average of just under 3 percent precrisis， to a projected average of 2 percent for 2012?2017. Similarly， in the euro area potential growth has fallen from 1.8 percent to under 1 percent.

The direct impact on China’s export sector has been very visible. For example， exports of machinery and equipment to the US， which contributed between 10?15 percent of China’s overall export growth in the early 2000s， look unlikely to recover as long as the U.S. housing market remains weak. Indeed， the contribution of these items to export growth has declined to around 5 percent in the post-crisis period.

One additional aspect of China’s export performance that is worth highlighting is that， while overall external demand has suffered as a result of the global financial crisis， China’s ability to gain inroads in building a larger share of those external markets appears to have been relatively unaffected. Even in 2008 when global trade collapsed， China was still able to build market share and， since then， the pace of China’s market share gains has broadly returned to the level prevailing prior to the global crisis. At an aggregate level， China has， over the past decade， managed to increase its share of world exports by an average of around 0.75 percentage points per year.

In 2008， as the global financial system melted down， China responded early and resolutely with a large stimulus package that was designed to prop up domestic demand and offset the large shock emanating from the coming col- lapse in external demand. This created the conditions for a dramatic step-up in investment from 42 to 47 percent of GDP. Much of that investment was concentrated in transportation， utilities， and housing construction. A direct consequence of this investment has been to remove many of the infrastructure bottlenecks that existed and increase the connectivity between provinces. Ultimately， this will serve to improve the competitiveness of China’s industry， in part as it facilitates industrial relocation to lower cost areas within China (particularly the central and western provinces).

As the global economy started to recover， China’s spending on infrastructure began to wane. This created a hole in aggregate demand that was quickly filled by an upswing in private sector manufacturing investment. It appears this manufacturing capacity is being built predominantly in a range of relatively higher-end manufacturing industries. Potentially， in the coming years， this growth in manufacturing capacity could lead to future increases in exports(as China sells these goods onto global markets). Alternately， this capacity could be deployed domestically through sales to Chinese industries and households. Finally， there is a chance that it could remain underutilized (which would open up a question of how and whether the financing for these investments will be serviced). At this point， the means by which this new capacity will be utilized remains an important question but very difficult to predict.

As discussed previously， one of the byproducts of the step increase in fixed investment has been an important increase in China’s demand for commodities. This growth in demand took off first in metals followed by strong import growth in machinery and energy products. Both private and public investment projects have proved to be very import intensive. There has been some opportunistic cyclical stockpiling of commodities and inventory data show stock building in upstream industries such as ferrous metal mining (about 15 percent y/y growth in 2011) and nonferrous metal mining (about 25 percent y/y). However， overall there appears to be little evidence of a secular rise in inventories which would suggest that this import demand is largely being used as an input to domestic production.

The sustained strength in imports of commodities and minerals has reinforced a dynamic that has been at work for several years now， going back to well before the global financial crisis. Over the past several years， imports have become more linked to commodities and minerals， where supply is relatively inelastic and global prices have been rising. At the same time， exports have become increasingly tilted toward machinery and equipment where supply is relatively elastic， competition is significant， and relative prices have been falling.

As a result， aside from 2009， China’s terms of trade has been steadily worsening. This may not be surprising from a historical context. Several other economies that have witnessed exportoriented growth (notably Japan and the NIEs) were affected by similar terms of trade declines along their development path. In China’s case， this dynamic is further fueled by the fact that， in both export and import markets， it has become so large as to no longer be a price taker. As a result， to some modest degree， China may well be generating a decline in its own terms of trade， creating a self-equilibrating mechanism that drives China’s terms of trade and creates countervailing downward pressures on China’s external surplus， through global prices.

Policy reform， demographics， and cost pressures

The Chinese government has rightly focused its policy efforts since the global financial crisis in a range of areas designed to accelerate the transformation of the Chinese economic model， improve livelihoods， and raise domestic consumption. Access to primary health care has been improved through the construction of new health facilities， particularly in previously under-serviced rural communities. A new government health insurance program has been launched nation-wide， with the objective of achieving near universal coverage by the end of 2012 and subsidies for a core set of prescription drugs have been introduced. In addition， the existing government pension scheme is being expanded to cover urban unemployed workers across the country by end-2012 and to make those pensions more portable within China. Also， the absolute level of pensions has been increased， particularly for the elderly poor.

In addition to the policy efforts taken by the government to lessen their external imbalances， raise household income， expand the service sector， and boost consumption， there are also some important underlying structural changes underway. Over the decades， urbanization has proceeded steadily and is now at the point where one-half of the Chinese population is living in urban areas. This process has tended to be commodity intensive， as new housing and infrastructure have been built to accommodate this growing urban citizenry， putting downward pressure on the trade surplus. At the same time， this shift has raised the standard of living for many Chinese， lifting millions out of poverty and creating a vibrant urban middle class. This process， undoubtedly， has been associated with a growing consumption of tradable goods， some imported from abroad but the majority produced within China. Thus， while manufacturing capacity has been expanding at a breathtaking pace， a large share of this has been deployed to provide goods to the domestic market. That is becoming increasingly evident as the domestic economy， and particularly the interior of the country， develops and companies relocate production facilities out of the coastal areas and closer to these fast-growing local markets.

A second important structural factor has been China’s unique demographics. China is fast approaching the point where its labor force will start to shrink and， already， the size of the cohorts that are younger than 24 years old has begun to decline. This naturally is going to tighten labor markets and put upward pressure on wages as the labor supply curve moves from perfectly elastic to moderately upward sloping， as is now happening. While China is far from a so-called “Lewisian turning point” it has entered a period where real wages are going to continue to rise and increasingly at a rate that is faster than productivity. However， this process is really in its infancy and has not yet translated into a dynamic whereby household incomes start to increase as a share of GDP and where Chinese households have greater resources available for consumption. These ongoing shifts in factor markets， both labor and other inputs， are clearly important and， over time， should lead to rising cost pressures. This will also have implications for the external imbalance. Nonetheless， it is still too early to conclude that rising cost pressures have been responsible， in a meaningful way， for China’s shrinking external surplus. As seen in the decomposition of the real exchange rate appreciation in Table 1 above， the contribution of the inflation differential has been relatively minor.

Conclusion

In conclusion， the decline in China’s external surplus has been impressive and should be welcomed. However， this adjustment has largely been the result of very high levels of investment， a weak global environment， and a pace of increase of commodity prices that outstrips the rising price of Chinese manufactured goods. While all three of these factors are likely to continue to put downward pressure on the external imbalance， this does not represent the“rebalancing” in China advocated by the IMF over the past several years. In particular， the available official data which cover the period through the end of 2010 do not yet indicate that the shift in the external imbalance is due to consumption rising as a share of GDP or national savings falling.

Certainly， the policy thrust of the 12th Five Year Plan is very much focused on raising household income， boosting consumption， and facilitating an expansion of the service sector. In the coming years， if these ongoing structural reforms are implemented， China does have the potential to handoff from an investment-driven to a consumption-driven decline in its external imbalance. If successful， this would ultimately prove a more lasting shift that would increase the welfare of the Chinese people and contribute significantly to strong， sustained and balanced global growth.

(Authors: from International Monetary Fund)