Explaining China’s Falling Current Account Balance

China’s surplus fell from 10.1% of GDP in 2007 to 5.2% in 2010.  Whether its current account will continue to decline or will return to higher levels seen in the mid-2000s is a subject of considerable disagreement.

On one side, Standard Chartered economists Stephen Green and Li Wei forecast that China’s current account balance will continue to fall to 2.3% of GDP in 2012.   Similarly, Zhou Xiaochuan, the governor of the People’s Bank of China, and Guo Shuqing, the chairman of China Securities Regulatory Commission, estimate that next year China’s current account balance will fall to 4.0% and 2.8% of GDP, respectively.  On the other side, the reputable World Economic Outlook conducted by the International Monetary Fund projects that China’s current account will remain steady at 5.2% of GDP in 2012 and begin a steady upward trend to 7.2% of GDP by 2016, a surplus of a whopping $850 billion. 

It is not clear how the International Monetary Fund arrives at their estimates given the economic trajectories of China and their major trading partners.  Like the economists at Standard Chartered and Chinese officials, this paper concludes that China’s current account balance will fall next year and will be under considerable pressure to continue to decline in the following years. 

To prove that this is the case we will show why the opposite (a rising current account surplus) would be extremely difficult.  To make the IMF forecast of a rising current account surplus correct, some combination of four unlikely scenarios would have to come true:

1.    China would have to gain a greater share of U.S. and E.U. imports.

2.    Similarly, China would need to gain a greater share of emerging market imports. 

3.    China would need to cut imports of commodities.

4.    Lastly, China would need to decrease household consumption from already unprecedentedly low levels. 

It is more likely that the opposite of each of these takes place, driving China’s current account balance down in the coming years.  But, just as it would be a mistake to think that China’s current account balance could rise in the current environment, it would be equally misguided to attribute its fall exclusively to increased household consumption.  There is no evidence that household consumption is growing faster than the economy, which means that it will have little impact on the decline in the current account balance in the short-term.

Demand in the U.S. and E.U.

Growth in China’s main export markets has not recovered from the Great Recession.  GDP in the United States has only recently eclipsed its pre-crisis peak.  In the European Union, GDP is expected to surpass its pre-crisis peak in 2012 but is at risk of falling back into a recession.  These two economies alone make up nearly 40% of China’s exports.  The outlook in other developed markets, like Japan, is also deteriorating. 

China’s current account will fall as a percent of its GDP in part because its domestic economy, which grew at estimated 9.5% this year, is growing faster than demand in its developed market trading partners.  As China’s economy grows in size relative to the size of foreign import markets, its surplus as a share of GDP will fall.

To see why this is the case, it is useful to look at China’s current account balance in terms of the GDP of its major trading partners. According to IMF estimates, the increase in China’s current account balance as a percent of U.S. and E.U. GDP over the next five years will be as large as the increase from 2000 to 2008.  Therefore, IMF forecasts imply that the world economy is on the brink of an even larger current account imbalance than we saw leading up to the Great Recession.  If growth slows in the U.S. and E.U. more than the IMF forecasts, which is highly possible, then China’s projected surplus will be an even larger share their GDP.

Emerging Markets and Political Resistance

China’s surplus could continue to rise if markets outside of the U.S. and E.U. increase their imports of Chinese goods.  But since February 2007, markets outside of the U.S. and E.U. have only increased their share of Chinese exports by 4.3%.  The relatively slow transition to demand in other markets is due to the global nature of the crisis and the strong correlation between growth in emerging economies and growth in major developed markets.

While emerging economies are a growing destination for China’s exports, they have not been a growing source of net exports.  This is largely because China depends on many emerging and developing economies for intermediate goods and raw materials, a subject that will be covered in the next section.  In fact, China’s net exports to emerging economies, as the IMF defines them, has fallen significantly since 2009 and reached only $12.5 billion from August 2010 to July 2011.  While this excludes some of China’s major trading partners, it does indicate that emerging markets may not be a source of China’s future surpluses.

In addition to slower demand growth from emerging economies, political resistance to China’s economic policies is mounting and may further damage trade relations.  The discontent is palpable in large emerging markets like Brazil where China’s exports pose a threat to Brazilian industry.  To respond to this economic pressure Brazilian President Dilma Rousseff launched the Bigger Brazil plan to resist currency appreciation, protect domestic industries with tax exemptions, and promote industry through investments by the Brazilian Development Bank.  Rousseff said, “With the launch of ‘Brasil Maior’ [Bigger Brazil], we are starting a campaign in defense of Brazilian industry against the often-unfair competition in the international marketplace.”  As China attempts to move up the value chain, it may run into similar disputes with more advanced economies like Korea, Taiwan, Japan, Germany, and others.

Commodity Imports and Investment-Driven Growth

Imports of mineral commodities (goods like crude oil, copper and iron) account for 5% of China’s GDP.  If China were to cut its imports of commodities it would lead to a significant increase in its current account balance.  But there are few indications that it has moved away from an investment-driven economic model and is likely to remain reliant on raw material imports. 

Recently China has increased its dependency on commodity imports at a time when commodity prices have steadily risen.  The 2008 stimulus package, which relied on investment in infrastructure and real estate, caused a surge in commodity imports.  There is speculation that in 2012 the government will re-start stimulus efforts with more expansionary fiscal policy and monetary easing.  If the new stimulus program reflects the infrastructure and real estate focus of its predecessor, it will continue to cut into China’s surplus.  This easing cycle may have just begun with the recent cut to the reserve requirement ratio, the first cut in nearly three years. 

The impact of commodity imports on China’s trade balance can be seen by excluding net imports of mineral products from the overall trade balance.  Since May 2010, China’s trade balance excluding mineral products has risen steadily while during the same period China’s overall trade balance remains flat.  The gap between the lines, or the amount of the mineral products China imports in a given year, increased from $138 billion in 2007 to $362 billion from October 2010 to September 2011.

Household Consumption

If China is unable to accelerate exports to developed or emerging economies and commodity prices remain high, then in order to expand its surplus household consumption would have to fall further relative to GDP.  But Chinese household consumption, already low by historical standards, is unlikely to decline much further.

The rise in China’s current account balance from 2001 to 2007 coincided with a steep decline in the household consumption share of GDP.  During the 2008 crisis, heavy investment levels further depressed the share of household consumption to a record low of 34% of GDP by 2010. This is unprecedented in China’s history and the history of other East Asian economies like Japan, Korea, and Taiwan and other emerging economies like India and Brazil. 

Decreasing household consumption further would be a political and economic problem.  The current leadership seems to recognize that their own survival depends on improving the welfare and incomes of ordinary citizens.  Many rural peasants and urban migrant workers have yet to see the full benefits of China’s economic growth and may turn against the government if their situation deteriorates.  Increasing household consumption is also an economic imperative.  Heavy investment capacity without a comparable increase in domestic demand (particularly at a time of weak global demand) would aggravate the problem of non-performing loans and rising government debt.  Increasing household consumption is also critical to transitioning to a more service-based economy, which would be more stable and utilize fewer natural resources.

Increasing household consumption as a share of the economy would be a healthier way to reduce China’s current account surplus than falling exports or increased commodity imports. But there is not yet evidence that this transition is underway.  Often strong retail sales are cited as evidence that household consumption is rising, but retail sales are only growing rapidly in nominal terms.  After adjusting for inflation they have fallen to levels seen before the crisis.  Perhaps, more importantly, retail sales are an inaccurate indicator of Chinese household consumption because they include government purchases and wholesale goods orders and inventories (i.e. goods before they are purchased by consumers). 

In sum, while household consumption is not likely to fall as a share of the economy, there is no evidence that it is rising, either.  Its impact on the current account balance therefore is not likely to be large.  For the time being, China’s falling current account appears to be caused by weak demand in external markets relative to growth in its own economy and its dependency on commodity imports.  Despite what the IMF models say, China’s current account is likely to fall next year.