China's Trade Surplus May Be an Illusion

The export of fake goods out of China is commonplace whether you are talking about designer bags, blockbuster movie DVDs, or "Mont Blanc" pens. Many European and U.S. holidaymakers take these knock-offs home with them -- some of them knowing they're counterfeit; others are unaware. Underground Chinese firms spirit such goods out of the mainland on a much larger scale.

Now we may we have identified another fake: the supposedly gargantuan global trade surplus China enjoys with the rest of the world. Much of China's trade surplus in 2005 was not trade at all, we think, but rather capital inflows (perhaps as much as $67 billion) disguised as trade. If so, this has major implications for China's trade policies, the yuan, and the way the U.S. deals with China.

China shocked much of the world last year when it reported that its global trade surplus had more than tripled to $102 billion or 4.5% of revised gross domestic product. To some trade hawks and U.S. congressmen this number provided yet more evidence that Chinese exports were contributing to the hollowing out of the U.S. manufacturing sector and stealing American jobs. And they believed this was achieved unfairly, that Beijing had manipulated its currency and engaged in suspect policies such as extending unfair utilities subsidies to Chinese factories and banning workers from joining trade unions to give China an economic edge.


  Because of China's comparative advantage in labor-intensive manufacturing, plenty of others accepted the big spike at face value. Given China's international image as the "world's factory," it made sense to them that China's exports should have swelled. But the sudden rise in the number puzzled economists.

Why? Well, first, we know countries that export a lot tend also to import a lot -- and none more so than China. It's a developing country with few natural resources, dependent on Asian and Western firms sending in components to be assembled in coastal factories. As a percentage of GDP, China's trade surplus was actually declining through 1999 to 2004.

Economists also puzzled over what had changed from 2004 (when the trade account was only $32 billion) to 2005. A big swing like that usually means something serious is changing within the domestic economy, such as either a big increase in savings or a drop in investment inside China's own borders. But when we looked, we could not see evidence of either scenario.


  So we took a closer look at the trade figures. The biggest puzzle was this: When you compare China's trade numbers with those of its key trade partners there are big discrepancies -- as high as 80% in some years. In theory, bi-lateral trade data should show that China imports roughly the same as, say, big trading partners such as South Korea or the U.S. export to the mainland. But in fact, China imports far more than other countries export to China and exports far less than its neighbors import from it.

One explanation for this is straightforward -- and not unique to China. Compare any country's exports to its partners' imports and you will also find some disparity in how trade is calculated. Exports are usually calculated on a "free on board" basis -- meaning their value at the point of customs. The value of imports is generally treated differently and includes things such as insurance and freight costs.

Trade experts estimate that the difference between exports and imports, which are higher in value, is usually about 15% of the value of the exports. But that was not enough to explain the huge gap that has existed between China's numbers and its partners'. So we turned to look at something special about China's trade.


  A big chunk of mainland goods pass through Hong Kong before shipping out to overseas markets. And how that is accounted for in the trade data makes a world of difference. Consider the differing approaches of China and the U.S. on this score.

China does not count all of the goods exported to the U.S. via Hong Kong so its export number is likely to be understated. Chinese trade authorities say they make this exclusion because their tracking data on the final destination of the goods leaving Hong Kong isn't always clear enough. The U.S. Commerce Dept., meanwhile, considers all exports out of the mainland that transit through Hong Kong -- and that ultimately arrive at U.S. ports -- in the final tally of Chinese exports to the U.S.

Not only that, it includes the value-added -- that is, the added mark-up on the cost of goods that Hong Kong trading firms impose for services rendered -- in Hong Kong. This method of trade accounting adds 20% to 30% more to the total value of outbound mainland goods, and we think the result is that the U.S. export number for China is exaggerated. As a result, the U.S. says its bilateral deficit with China was $202 billion in 2005, while China says it was $114 billion. The correct answer should be somewhere in between.


  But that did not solve our problem completely either, because the trade gap remained. In fact, when we looked at the gap as a percentage of total trade, it has been falling since 2001. Although China exports less than its trade partners import, it is now exporting a lot more vis-á-vis partner imports than four years ago.

So we played with the numbers some more and believe we have found evidence that there is a problem on the Chinese side as well. Some mainland trading firms are doctoring the export and import invoices submitted to Chinese customs officials to get around capital controls and bring in more foreign hard currency than their trade transactions would justify. The economic incentive is clear enough: The Chinese yuan is widely expected to appreciate in the years ahead, and is an attractive investment for companies or speculators.

Why all the subterfuge? China's capital account restrictions make it difficult to bring U.S. dollars onshore and convert that money into yuan for domestic companies and ordinary Chinese people. But Chinese exporters and trading companies have a far easier time, due to the nature of their business. An exporter willing to exaggerate an invoice handed over to local authorities could bring far more hard currency into the country than warranted by the value of goods sold.


  This "mis-invoicing" of trade was commonplace in the last decade, but back then it was a way of getting money out of China. Now we think it is being used to bring funds in, given the strong likelihood the yuan will appreciate in value relative to foreign currencies down the road. This again inflates the value of Chinese exports.

The exaggeration in the value of Chinese exports is probably getting another boost from the phenomenon of transfer pricing. This involves the price at which transactions between units of multinationals take place. When a mainland company trades with a sister company or affiliate offshore, the value of goods depends a great deal on where the company wants to book the profit.

Usually firms will ensure that profit on trade transactions within a company are booked in lower tax jurisdictions. And that has usually meant offshore in the past, given the relatively high tax rates on the mainland compared to Hong Kong and other regional economies.


  But with the yuan now appreciating against many regional currencies, that is starting to change. Imagine a mainland-based laptop maker with a production facility at home and a subsidiary in Hong Kong. This Chinese company has an order to sell a laptop with a retail price of $1,000 to a computer store chain in the U.S.

In the past, in order to minimize profit and hence tax bills, the parent company would sell the computer first to the subsidiary at a price very close to the actual cost of production, say $500, and then the subsidiary would ship it off to the States. Now, with the yuan starting to appreciate, there is an incentive to actually book a bigger profit or to price this laptop at $800. In other words, the value of the laptop ultimately shipped overseas would rise. And this trend, multiplied over thousands of price transfers could be inflating China's trade surplus.


  We ran the numbers to try and work out the likely impact of mis-invoicing and transfer pricing and were surprised by the results. Our numbers show that the China's trade surplus could have been as small as $35 billion in 2005. Trade could have disguised some $67 billion of non-trade capital inflows. We made a long list of assumptions to get to this number, and we are not claiming that it is absolutely accurate. But it does give a hint as to the potential scale of these foreign currency inflows.

So, say we are right. Then there are two big implications for China's policymakers. First, China's booming trade surplus does not necessarily indicate new and real pressures for yuan appreciation. This is another reason for cautious currency appreciation. As soon as the yuan reaches a point where expectations of appreciation disappear, China's trade surplus could suddenly be sharply reduced. Second, Beijing has said that it will try and bring down the trade surplus in 2006.

There have been calls to increase the tax rate on foreign-invested enterprises (which concentrate in the export sector) or to reduce the value-added tax rebate exporters enjoy. But if we are right, then the case for such policies is weak.

Before it's here, it's on the Bloomberg Terminal.