China's first current account deficit since 2001 won't change the world

China's first current account deficit since 2001 won't change the world
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China’s first-quarter 2018 current account was in deficit, which has not happened since before China joined the World Trade Organization. While the reduction in China’s external surplus is a welcome development, trade frictions will continue between China and its trading partners.

China’s current account reflects its exports and imports of goods and services, as well as its net earnings on Chinese assets held abroad versus foreign assets held in China. The Chinese still run a substantial trade surplus, around 4 percent of its GDP in 2017.

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Partially offsetting that is a significant deficit on its services trade. China is making net payments for foreign providers of financial, accounting, transport, tourism, education and other services.

 

Will these trends continue? For various reasons, we can expect China’s current account position to remain in a small surplus or occasional deficit, as services trade continue to offset in large part China’s continuing trade surplus. Will this trend power the global economy as U.S. trade deficits have? Not to the same extent.

First, China is increasing the share of consumption in its domestic economy. Chinese per capita incomes are rising, and Chinese citizens are spending more on consumer goods while they are also consuming more services.

China has long recognized that it needs to improve its social safety net, to provide for the elderly, infirm and unemployed. The International Monetary Fund (IMF) and others continue to urge China to more rapidly expand social services — for the good of its citizens but also to reduce the excessively high household savings rate.  

The overall national savings rate is declining, slowly, as is the very high national investment rate. But it will be many years before the Chinese consumer drives the global economy to the same extent as the U.S. consumer.

Second, China’s population is aging rapidly, and its work force is shrinking due to the one-child policy. This means that China cannot rely on past cultural norms of families providing for their elderly.

There will not be enough working-generation Chinese to comfortably care for a growing elderly cohort. That will likely drive more government spending on social services, although this transition will not be smooth.

Third, China’s overall policy direction, including “Made in China 2025,” can be expected to lead to more targeted investment strategies and should draw resources from the old-line heavy industries that drove China’s development in the past.  

What is less clear is how this will affect the investment/consumption mix in the economy, given that the “Belt and Road Initiative” is doing the opposite by spending on these traditional infrastructure-related industries.

China’s policy of exerting more state control over all aspects of decision-making, and the on-again, off-again lending practices hint that the decline of the traditional state-owned sector of heavy industry may evolve much more slowly.

Ultimately, China’s continued centralized planning and control will restrain growth of more dynamic, truly private initiative, and limit the ability of the economy to become more consumption based.

Fourth, China’s domestic debt buildup will also impede economic rebalancing. Many of the heavy industries contributing to global overcapacity are not profitable and rely on Chinese lenders continuously rolling over company debt.

At the same time, China’s regulators are trying to reform banking and other lending practices, but when faced with prospects of widespread defaults, regulators are prone to ease restrictions on credit provision.

This limits financing sources for private enterprise and households, meaning they will continue to rely on unregulated finance (e.g., shadow banking) or in the case of households, to maintain their high savings rate.

Fifth, regarding China’s exchange rate policy, the authorities can be expected to manage exchange rate trends, while continuing to espouse an ultimate goal of exchange rate flexibility.

China is unlikely to willfully initiate a rapid depreciation of its currency in order to promote exports but it nonetheless will maintain the relative competitiveness of its labor intensive exports. Many Chinese are still employed in those sectors, and lower income countries such as Vietnam are already taking jobs from Chinese workers.

Some speculate that China might sell off its large holdings of U.S. government debt to push its currency down and the U.S. dollar up, but this is highly unlikely as it would ultimately be self-defeating.

Few other government debt markets could absorb large Chinese purchases, and China will want to keep its foreign exchange holdings in highly liquid assets. Furthermore, a rapidly declining yuan, the Chinese currency, would fuel more capital outflows as Chinese individuals and corporations sought to move their money abroad to protect its value.  

China relies on administrative controls to prevent such outflows, but controls are difficult to enforce and promote creative trade and investment strategies to circumvent restrictions.

In sum, Chinese imports of goods and services will generate demand for production in its trading partners. A growing Chinese economy will sustain that demand.

But given Chinese demographics and the internal inconsistencies in Chinese policies described here, including heavy state control, China’s consumption will increase only gradually. Investment and exports will remain key drivers of growth to the detriment of resolving trade disputes.

Meg Lundsager is a senior fellow at the Wilson Center, consulting on international economic, financial and regulatory issues. She is the former U.S. executive director and alternate executive director at the IMF.