Author: Brad Setser, Council on Foreign Relations
There was one point of consensus among financial analysts and journalists following China at the turn of 2019. China was headed toward a current account deficit and would cease to be a net lender to the world. It wasn’t an implausible forecast. China’s current account deficit fell over the course of 2018 and US tariffs seemed set to knock China’s exports back a notch or two. But the potential impact of this swing was often over-stated and does not characterise the real risks.
A small current account deficit isn’t that different from a small current account surplus. China had the necessary fundamentals — little external debt, a high level of reserves relative to its short-term debt and more state assets abroad than external debt — that would allow it to run a modest external deficit with little consequence. China wasn’t going to be forced to change its policy approach because of a statistically insignificant swing into external deficit.
And this forecast now suffers from one substantial problem. China’s trade and current account surplus surprised most and jumped back up in the first part of 2019. Exports aren’t doing that well, but imports are down substantially. The current account surplus is now around 1.5 per cent of China’s GDP — and it is more likely to reach 2 per cent of GDP than turn into a deficit.
The fall in China’s surplus in 2018, it turns out, was likely a reflection of the big stimulus that China implemented in 2016 and 2017 and perhaps some stockpiling by Chinese technology companies Huawei and ZTE ahead of President Donald Trump’s trade war with China. China pulled back on that stimulus over the course of 2018 — and only moderately reversed course as the trade war intensified. Without the stimulus from unconstrained credit growth through shadow banks, China’s march toward current account balance went into reverse.
There was also a technical problem with a lot of the forecasts that projected a future Chinese external deficit. They were based heavily on a single outlying data point — the large current account deficit that China ran in the first quarter of 2018. The US$35 billion deficit in the first quarter of 2018 turned into a US$50 billion surplus in the first quarter of 2019, generating an annualised swing of close to US$300 billion dollars.
But rather than focussing on the precise current account balance, it is worth stepping back and considering China’s overall trade. China still runs a large surplus in manufactured goods — a surplus that now totals US$1 trillion. China runs an enormous deficit in commodities and a decent sized deficit in tourism and educational services.
Australia should understand this pattern well — Australia exports commodities, vacations and degrees to China and gets a lot of manufactures back in return. The size of the commodity deficit is a function of commodity prices — and the manufacturing surplus is now rising due to weakness in China’s imports and decent growth in China’s exports to markets other than the United States.
The big surplus in manufactures now more than covers the deficit in commodities as well as the tourism deficit (which is very poorly measured), leaving China with a substantial overall trade surplus — one that isn’t likely to go away in the near future.
But focussing on the current account also misses a potentially more important change in China’s balance of payments. China, more or less, stopped adding to its reserves. The current account surplus — plus some inflows into China’s bond and equity markets — now funds a mix of large-scale lending by the state banks, including for the Belt and Road Initiative, and the build-up of offshore assets by private Chinese savers, including capital flight. These structural outflows reduced the need for the People’s Bank of China to intervene in the foreign exchange market as they balance the net inflow of foreign exchange from trade.
That change happened five years ago. China’s government is no longer a big buyer of the rest of the world’s bonds, even though China still runs a modest current account surplus.
The risk to the world right now isn’t that China will swing into a small external deficit — a rise in China’s imports or a slowdown in China’s exports that opens up more space for other exporters of manufacturers globally would be welcome right now. The risk to the world is that China swings back into a large external surplus.
China’s national savings rate is still exceptionally high, at just over 45 per cent of its GDP. If investment falters, that high level of savings creates the raw material for a large current account surplus (a surplus reflects savings that isn’t used in the domestic economy). And it isn’t too difficult to imagine a path back to large surpluses, even if right now China’s government makes it hard for China’s domestic savers to move their money abroad.
If those controls were to lose effectiveness, China’s currency could fall — perhaps substantially — and China’s exports would surge. That would be an unpleasant deflationary shock for a global economy that is already losing momentum.
Brad Setser is the Steven A. Tananbaum Senior Fellow for International Economics at the Council on Foreign Relations.