I never worry about the problem. I worry about the solution. – Shaquille O’Neal
China’s current account surplus deteriorated steadily from a peak of 10.3% of GDP in 2007 to only 0.4% in 2018 (Chart 1). When it suffered a deficit in 1Q 2018, the first in 17 years, the market started worrying about the emergence of a structural deficit. Not so soon, in my opinion. Such a worry fails to distinguish between the cyclical and structural forces behind China’s current account. The consensus that 2019 will see a current account deficit may be wrong.
The drag on China’s current account in 2018 came from surging imports on the back of weak exports. The latter was affected by the Sino-US trade war, but the imports were not boosted by strong growth as China’s growth was declining throughout last year. Rather they were boosted by a big rise in the prices of two major imports – oil and semiconductor1 (Chart 2). The market estimated that these price hikes had pushed China’s oil and semiconductor import bills higher by USD77 bn and USD53 bn, respectively, in 2018 from 2017, and eroded almost half of China’s current account surplus last year.
However, these price hikes are not likely to repeat in 2019. Semiconductor prices seem to have entered a cyclical decline while oil price is unlikely to surge again. The cyclical weakness in global demand may even push oil and commodity prices lower. Crucially, China plays a role in influencing the cyclical price adjustment.
Because of its market size, China is not simply a commodity price taker – i.e. commodity prices are also sensitive to changes in China’s growth and policy changes so that the value of its major imports vary with its economic cycle. Slower Chinese growth tend to drive commodity prices lower, expanding its trade balance; and vice versa. China is in a cyclical growth slowdown, so commodity prices are more likely to weaken in 2019 than to rise further, ceteris paribus. Beijing’s selective policy easing in this cycle and focus on boosting private-sector spending rather than public and housing investment is much less commodity intensive. Furthermore, China’s attempt to build up massive semiconductor production capacity will only exert downward pressure on chips price. All this suggests that China will likely pay less for its major imports this year so that, contrary to conventional wisdom, its current account surplus will stay, or even rise.
Beyond the short-term, China’s current account is indeed going through a structural downward shift so that it will likely run a much smaller overall current account surplus in the future than it did in the past 25 years. There will also be periods of deficits, but it is too early to conclude that it is headed for a structural deficit.
China’s export capacity constraint is current-account negative. Being the largest goods exporter in the world and accounting for 13% total global exports, China’s export sector is so big that it cannot possibly keep gaining market share. Indeed, the size of its export sector peaked 10 years ago (Chart 3).
But the biggest current-account erosion force comes from the changing structure in China’s imports. As it gets richer and rebalances towards consumption-led growth, but with an underdeveloped domestic service sector, Chinese demand for service imports will continue to rise. Already, China’s service trade deficit has been growing and eroding the current account surplus steadily (Chart 4).
Furthermore, China’s goods trade surplus, the largest contributing factor to the current account surplus, has long been sustained by processing trade which imports components to make finished products for exports. In this trade, exports determine imports so that a slowdown in export demand will automatically lead to a slowdown in import demand. This has helped keep China’s goods trade in surplus through the economic cycles.
However, the importance of China’s processing trade has decline over time as more imports are retained for local use and domestic manufacturers use more local components. Meanwhile, China’s imports of primary products (including commodities) have increased steadily (Chart 5). Unlike the processing imports for re-exports, primary imports do not automatically fall as exports weaken. Since 2011, primary imports have been larger than processing imports, thus weakening the processing trade’s support of the current account surplus.
Finally, continued industrialisation and policy using infrastructure spending to boost economic growth will boost imports for commodities and capital goods. That is negative for the current account, ceteris paribus.
Despite all these negative forces, a persistent current account deficit is still not likely because conflicting forces are in play. Rather it will likely see a mix of small surpluses and small deficits, depending on the economic cycle and the government’s economic policies.
Continued structural rebalancing from industry-based investment-led growth to service-based consumption-led growth makes the economy less commodity-intensive. Meanwhile, China is diversifying its exports to new markets, notably to countries along the Belt and Road Initiative routes (Chart 6) to reduce its reliance on the US market. It is also boosting new industries, notably in semiconductors, robotic, aircraft, bio-tech, AI, electric vehicles, aerospace and other technologies (as highlighted in the “Made in China 2025” industrial policy). All these moves will reduce long-term import demand for capital goods and commodities and increase exports and are, thus, current-account positive2.
The point is that there is no a priori reason to believe that China’s current account will fall into a structural deficit any time soon.
With China’s current account more-or-less balanced since 2018, the renminbi is fairly valued from this perspective. As long as the capital account is not fully opened, any exchange rate pressure is quite manageable.
During the years of large current account surpluses and when portfolio flows were not significant, short-term capital outflows by Chinese companies’ decisions on managing their FX exposure were not important in affecting the FX market and China’s monetary policy. But now with a small surplus and rising importance in portfolio flows, those decisions will have a bigger impact on the market and FX policy.
The PBoC has already shown its policy preference to cede control on the exchange rate3 as China moves towards the “Impossible Trinity”4. This means that there will be more two-way volatility in the renminbi exchange rate going forward as the PBoC allows it to adjust to the current account swings.
In the longer-term IF China’s current account moves into a permanent deficit, the implications on China’s policy management and global markets could be significant because the deficit will need to be financed by capital inflows. China will have to decide how much currency depreciation it will tolerate. This will dictate its decision on setting the level of domestic interest rate to retain/attract capital flows and, hence, constrain its monetary policy on managing domestic demand growth.
For the markets, when China turns from a net capital exporter to a net capital importer (as manifested in the current account deficit), its competition for funds would push up the global cost of capital. This China impact will depend on the size of its deficit. Take the market’s assumptions for China’s current account deficit in 2019 of 0.5% of GDP and 2020 of 1.0% of GDP, and assume China will grow by 6.2% YoY. China would then add USD72 bn in 2019 and USD153 bn in 2020 to the world’s demand for capital – big sums but not insurmountable. But the current account deficit may not necessarily be funded completely by foreign savings. China could use its large FX reserves (more than USD3 trn) to soften the policy constraint it faces and lessen the upward pressure on global funding costs.
In a nutshell, China’s current account may not fall into a structural deficit so soon so that its impact on the global cost of capital will likely be small. After all, it is structurally a high-saving country, with a national savings rate of 46%5, how can it suffer a permanent current account deficit?
1 Oil traded between USD75 and USD80/bbl last year, up from the USD55-65 range in 2017, while semiconductor prices surged, with the DRAMeXchange index jumping to over 27,000 for most of 2018 from 15,000 at the beginning of 2017.
2 Of course, if these initiatives fail, China will remain dependent on high-tech and commodity imports and face persistent current account erosion.
3 See “Chi on China: Mega trends of China (5): Evolution of a New Monetary Framework”, 9 February 2018.
4 The Impossible Trinity paradigm states that under an open capital account, a central bank can only control either the interest rate or the exchange rate, but not both. Hence, the central bank faces a policy trilemma of three variables: the capital account, the exchange rate and the interest rate.
5 Though this is down from over 50% of GDP.