China's Trade Surplus Gets Dangerous
Think you've already seen the biggest surpluses out of China? Are you sitting down? We believe China's current account surplus will balloon to $400 billion this year, or 12.8% of gross domestic product, up from $256 billion in 2006. This is a massive number, the biggest surplus—in dollar terms—the world has ever seen. Our forecast is also significantly bigger than that of the World Bank (8.3% of GDP), the International Monetary Fund (10% of GDP), and as far as we can tell, the rest of the street, too.
The general assumption out there seems to be that the surplus will grow this year by roughly the same pace as last year. In contrast, we believe that China's overall surplus is accelerating, and that Beijing's administrative efforts to control it are having a marginal effect at best. This forecast is so large, and so sudden, that it almost seems unbelievable. We do not make it lightly. Here is our thinking.
First, the processing export boom is continuing. The largest part of China's surplus comes from processing: Import $100 worth of goods, add labor and other costs, plus a margin, and export $130 worth of goods. That $30 value-add becomes a surplus on a huge scale, since half of all China's trade is processing. Add more processing investment via foreign direct investment and domestic firms, and you get more processing, as well as a bigger processing surplus.
Increase in Value-Add
The key here is that this bit of the surplus only gets smaller if processing trade growth goes to zero and then reverses. Any growth whatsoever in processing trade delivers a bigger processing surplus. Processing trade growth is clearly decelerating, as global growth calms. However, it is still growing at a significant pace.
In the first quarter, processing imports grew 11% year-on-year, compared to exports' growth of 25% year-on-year. As a result, the processing surplus in the January through March period alone was $54 billion, a full 70% larger than in the first quarter of 2006. In addition to the simple mechanics of more investment, the key here is increasing amounts of domestic value added. Think onshore-produced chemicals going into plastics; think onshore-manufactured steel going into white goods; think onshore firms moving up the value chain and producing auto parts; and so on.
But the processing story is an old one. And while processing creates the country's natural disposition to large surplus, if China is importing vast volumes of raw materials and capital goods for its own industry, as it did before 2005, then the trade account will be in rough balance. The big change in the dynamics of the past two years has been the unexpected recovery in the 'real' trade deficit. China's hardly exists.
Getting the Goods
Why? The initial stimulus was the collapse in 'real' import growth in 2005. This was partly an inventory adjustment, particularly as raw material importers attempted to wait out high global prices, and partly the result of administrative measures which hit investment. Then import growth recovered after inventories had been emptied and controls relaxed.
But at the same time, real export growth accelerated. Why? Because thanks to all the investment in the steel, aluminum, chemicals, auto parts, etc. sectors, China was ready to become a major capital-intensive goods manufacturer. By our very rough calculations, 10 years ago some 40% of China's exports were capital-intensive. Now that figure is approaching 60%.
We have to ask if this is going to change. One school of thought says it will, meaning the surplus will stop growing soon. It argues that the massive 2003-05 investment wave unwittingly resulted in excess capacity, and as a result there was diversion of production into overseas markets.
So—this line of thought goes—in 2007, the combination of slowing investment (and thus capacity) growth plus a revival in domestic demand will mean that this production will be diverted back into the home market. Cue a reversal in real export growth.
Widespread Corporate Ambition
We have two problems with this scenario. First, we doubt there is any significant investment slowdown. Year-on-year growth rates in investment in both heavy and light industry are falling, but absolute amounts of fixed asset investment (FAI), at least according to the official figures (and if there is any bias in the numbers, it is downwards), are holding up. According to official numbers, there was more investment in Q1 2007 than in Q1 2006 in just about every bit of manufacturing you would care to name.
If we consider also China's low real interest rates, widespread corporate ambition to gain market share abroad, and the implicit subsidies which are locked into much of this production, then it seems to us that continued investment is an entirely reasonable choice. "If you build it, they will buy it," seems to be current maxim of PRC industry. So, in terms of overall capacity growth we see no significant room for a new view. We also note that it takes about six to 12 months for investment to come on stream, so given today's numbers, we will still be seeing new capacity coming on stream next year. That's the supply side.
On the demand side, we have our doubts about the "revival in domestic demand" scenario. This is partly because we always doubted there was any substantial slowdown during the second half of 2006. Certainly the proxies we use to measure domestic demand have remained strong throughout.
So that gets us to the forecast. In short, we believe the current pace of trade surplus accumulation will continue to the end of the year, and into next. That means a total-goods trade surplus of $370 billion, as measured by China's State Administration of Foreign Exchange (SAFE), and $308 billion as measured by the Customs Bureau. Add in the other parts of the current account, and we easily reach our total of $400 billion for the world-beating current account surplus.
What about other types of flows? We see the financial account (known to many as the capital account) moving back to its usual surplus. In 2006, there was some funny business going on with the central bank swapping its foreign exchange reserves with the large domestic banks, which meant an outflow from the FX reserves, but in 2007 we believe the banks will resist this more strongly and the scale of the swaps will be much smaller.
Adding up the foreign direct investment flows in and out, we see the financial account at a $60 billion surplus. Add the current and financial accounts together, and the result is an increase in the FX reserves of some $540 billion. That takes us to $1.6 trillion in FX reserves by yearend, or $1.4 trillion if $200 billion is taken by the new FX fund that China is setting up. Two trillion dollars in FX reserves is likely next year.
A Trillion-Dollar Fund?
Such big numbers have implications. If we are right, several things are going to happen this year. One, China's liquidity challenge is going to get even greater, with interest rates being pushed even lower, asset prices continuing to inflate, and the People's Bank coming under even more pressure to sterilize FX inflows. Expect global markets to speculate again that another big one-off currency appreciation is in the works.
Two, the ever-more-massive FX reserves are going to mean that China will not only become an even greater buyer of U.S. Treasuries, but also will have money to spare to buy more. The new FX fund could very quickly expand from its "seed" capital of $200 billion. A $1 trillion China fund is not unimaginable at this point.
Three, Beijing is going to have to become much more aggressive on its readjustment policies. However, the action that is needed demands serious coordination across government. There is no silver bullet, including the Chinese currency, to solve this imbalance problem since it goes down deep into the structure of the PRC economy. It requires fiscal change, land management change, changes in the way banks allocate capital, changes in the pricing of energy, changes in the way local official performance is judged. And all that is difficult to forge—really difficult.
Fourth, of course, such a huge surplus number is only going to sharpen criticism in Washington, particularly as exports enter U.S. markets that other exporters do not reach (think chemicals). And it is going to increase political pressure for the Chinese currency appreciation, even if the yuan can only ever be a small part of the rebalancing agenda. Given that Beijing is not willing to move on the yuan fast enough to salve Washington's demands, it is now difficult to be optimistic about the prospects of avoiding substantial trade protection in 2008. This is all getting a little dangerous.