Behind the headlines, China’s large current account surpluses are becoming a thing of the past
- The transformation of China’s balance of payments position will have a significant impact on its economy
- It’s necessary to understand how its large surpluses came to be, and how, as Beijing seeks to rely less on investment and more on consumption for growth, much smaller surpluses – or even a persistent deficit – may become the norm
With a torrent of tweets and headlines about the Sino-US trade war, economic data and erratic central bank policies, it is easy to get distracted by short-term noise and lose sight of the big picture. Alongside other mega trends in China, such as long-term technology progress and changing demographic patterns, the transformation of China’s balance of payments also stands out.
Before delving into the details, it is worth first explaining the importance of balance of payments. The balance of payments, which consists of two general accounts – the current account and capital account – essentially captures the economic and financial interactions between the country and the rest of the world.
In general terms, the current account records all trade-related activities, while the capital account documents how the trade surplus (or deficit) is being invested (or financed). The balance of payments should, therefore, in theory, always balance.
While the sum of the current account and capital account is always zero, their respective balances can vary over time. In China’s case, the current account has recorded surpluses since the early 1990s, with the amounts swinging wildly. There was a noticeable upswing in the early 2000s after China entered the World Trade Organisation, which made it a formidable competitor in international trade.
While the success of the export-driven growth model helped create jobs and economic prosperity, the large current account surpluses also brought challenges.
Internally, the strong inflows of export earnings flooded the domestic system with liquidity. Under a controlled capital account and fixed exchange rate, this liquidity had to be mopped up through serious monetary tightening to prevent runaway inflation.
But despite a sharp rise in banks’ reserve requirement ratios – from 7.5 per cent in 2006 to 17.5 per cent before the financial crisis – inflation still climbed to above 8 per cent.
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Externally, under the existing rigid capital control regime, China had to recycle the booming trade surpluses via official reserves. As the latter need to be invested in liquid and safe assets, a lion’s share of these reserves ended up in the US Treasury market.
Some believed that China’s seemingly insatiable appetite for US bonds at the time had significantly suppressed US interest rates, creating a global imbalance that eventually led to the financial crisis.
While there is no empirical evidence to support China being the culprit, many – including the former Federal Reserve chairman Ben Bernanke – believe that the “global saving glut”, led by China, at least partially contributed to the low interest rate environment that preceded the crisis.
Hence, understanding what caused China’s trade surpluses and how these surpluses may evolve going forward could have important implications for China and the world.
Our analysis shows that historical variations in China’s current account position have a close correlation with the differences between its savings and investment. This is consistent with standard economic theory positing that countries with surplus savings will export more than they import, while those with a savings deficit have to borrow from overseas to fill the void.
It is easy to see that the GDP share of both savings and investment in China is due to decline in the coming years. High household savings – traditionally driven by the lack of social safety nets, rising working-age population, and a result of the one-child policy – have started to fall as the ageing population and increased state-pension contributions have reduced households’ discretionary savings.
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The rebalancing of the economy – from investment to consumption-driven growth – has also dampened the investment rate in recent years. A continuation of these social and economic transformations should lower China’s savings and investment rates from levels that are still among the highest in the world.
The future of the current account position will depend on the relative moves of the GDP share of both savings and investments. Our analysis shows two interesting results. First, it is by no means inevitable that China will enter a period of current account deficits, although the era of large surpluses has clearly ended.
Second, the common perception that a current account surplus is “good” and a deficit “bad” is misplaced. An entirely plausible scenario of China undergoing successful economic reforms and liberalisation could see its current account recording small, but persistent, deficits in the coming years.
Aidan Yao is senior emerging Asia Economist at AXA Investment Managers
