China: US$100 billion Trade Surplus. So What?
morganstanley.com
Andy Xie (Hong Kong)
Bottom Line
Big trade surplus won’t change the yuan policy: China is a combination of a modern economy with 20% of the population and a subsistence economy with 80% of the population. For political stability, the macro policy is set for the 80% of the population with low productivity. This is why the trade surplus will not, in my view, make China shift to a strong currency policy.
The big trade surplus may last to 2008: The savings rate has increased sharply due to cyclical factors. As investment slows, the savings rate is declining more slowly, causing a big savings and trade surplus. The situation may last for another three years based on the experience from the cycle 10 years ago.
The data improvement may account for half of the increase in the 2005 trade surplus: The discrepancy between the customs and balance of payment data widened from 2002-04. It narrowed in 2005, which could explain half of the increase in the trade surplus – i.e., China’s trade surplus has not increased as much as many might think.
Summary & Conclusions
China’s US$102 billion trade surplus in 2005 and the reported changes in China’s foreign exchange reserve management have raised expectations of a substantial yuan revaluation in 2006. Don’t hold your breath! Not much is going to happen, just like in 2005. The return of the yuan revaluation story is just to fill an emotional void in the market. Speculators need something to speculate about.
The surging trade surplus reflects weakening investment, I believe, similar to what occurred in the cyclical downturn 10 years ago. China is experiencing significant deflationary pressure in 2006 due to overcapacity in most industries. A major revaluation would push China into serious deflation. It would be irrational for China to do this.
Furthermore, China must keep financial stability by maintaining the expectation of currency appreciation without actually doing it in order to maintain low interest rates when the US interest rate is much higher. A substantial revaluation would destroy the appreciation expectation. It would force China to increase interest rates, which would be destabilizing, as Chinese companies have high leverage and low profit margins.
I believe that China will move the yuan spot rate up bit by bit to sustain the revaluation expectation. Yuan appreciation of 2% against dollar in 2005 is likely. A 3% appreciation is possible but not likely, in my view.
Why is the trade surplus rising?
China’s trade surplus is not rising by as much as many might think. The improvement in customs data could explain half of the surplus increase. The discrepancy between customs and balance of payment data widened in recent years. From 2002-04, China reported an US$88 billion trade surplus in its customs data but US$148 billion in its current-account data. The difference was 68% during this period compared with 27% in the preceding 10 years. In the first half of 2005, the difference was 35%. It seems that the customs data have improved.
The balance of payment data for the second half of 2005 have not come out yet. I believe that the difference between customs and current-account data was similar to that in the first half. That would imply that about half of the increase in the trade surplus is due to improvement in the customs data.
Aside from the data issue, China’s trade surplus did increase in 2005. I believe that this was due to decelerating fixed asset investment (FAI) and the consequent slower growth in demand for imported equipment. China’s data still showed 27.8% growth in fixed asset investment for the first 11 months of 2005 compared with 28.9% for the same period of 2004. I think that the 2005 data may be overstated. Foreign direct investment (FDI) in the first 11 months of 2005 actually declined to US$53.1 billion from US$54.1 billion for the same period in 2004.
Overcapacity had already begun to plague many major industries like steel and auto at the beginning of 2005. The sentiment towards property began to cool in the middle of 2005. It is quite hard to believe that the FAI kept going at the same pace despite the negative environment for investment.
China’s FAI in 2005 probably surpassed US$925 billion. A minor FAI slowdown could easily lead to a US$32 billion increase in the 2005 trade surplus – the increase after adjusting the data problem.
Big trade surplus should last for three years
China’s macro-economy is highly unusual. It is a low-income economy with an extremely high savings rate. China’s gross savings rate was probably 46% in 2005 after taking into account the recent upward revision in GDP. There are demographic, structural, and cyclical reasons for the high savings rate.
First, the urban one-child policy has led to an unusually high and rising savings rate among the urban population, which accounts for about 60% of national income. This policy-induced savings trend is unique in the world.
Second, the Chinese government pays little for social services. The social safety net is limited to ex-state-owned enterprise (SoE) workers. Schools and hospitals, though government-owned, collect from students and patients for funding.
Third, Chinese government revenue correlates with FAI rather than the profitability of such investment in future. This revenue rose by 17.5% per annum from 2001-05, and the share of the revenue in GDP rose by 2.6 percentage points. The revenue growth has gone mostly into decreasing the fiscal deficit and funding investment – i.e., boosting savings.
Four, the property boom and commodity inflation have redistributed income to state-owned monopolies, property companies and local governments, which invest their income. The increased household expenditure on property purchases is a form of forced savings. Rising prices have scared the households into buying early. Coal, oil and property may have accounted for 5.3% of 2005 GDP for such distribution. Other commodities like iron ore and alumina have also contributed to the inflation tax.
The third and the fourth are cyclical factors. They contributed to 80% of the 9.6 percentage-point increase in the gross national savings rate, I believe. While the investment growth rate is decelerating, the cyclical increase in savings rate is not receding at the same pace. The difference is the large savings and trade surplus.
The current cycle resembles the cycle 10 years ago. The trade surplus in the previous cycle peaked in 1998. If the same pattern is followed, China’s trade surplus should peak in 2008.
Yuan won’t revalue substantially
The Chinese currency is not going up substantially. The bottom line is that China does not allow recession to shake out bad businesses, because it is worried about social instability from a significant economic downturn. A strong currency would inevitably lead to a shakeout in China’s economy. It might be a good thing for China in the long term. But for now, it is up to the politicians, and therefore a big yuan revaluation is just the market’s wishful thinking, I believe.
Another way to understand China’s macro-economy is to think of it as two economies. About 20% of the people in China have joined the global industrial economy. They are productive and create all the country’s value. However, 80% of the people are still in the low-productivity rural and subsistence service economy. China’s currency value would be much higher if there were no political pressure to look after the 80% of the low-productivity people. But, the political imperative is that China must set its macro policy for the low-productivity, not high-productivity people. This is why the country needs to keep currency cheap and the interest rate low.
China’s currency is likely to crawl up bit by bit this year, because it would be good for the country’s stability. The stock of hot money in China, even though the inflow has stopped, is very high (probably 15% of GDP). China’s six-month deposit rate is 2.07%. After deducting the 20% tax on interest income, the effective six-month deposit rate is 1.66%. The six-month LIBOR is at 4.74%. The spread between the yuan and the dollar deposit rate for speculators is a negative 3.08%. Without the revaluation expectation, not only would the hot money leave, but also there would be capital flight. Even though China has capital account control, the large changes in capital flows suggest that the capital account is very porous.
To sustain the revaluation expectation, official chat is important. When American officials are talking up the yuan, Chinese officials do not have to do anything. When American officials stop talking about the yuan, Chinese officials have to talk it up themselves. Of course, talk is cheap. To back it up, the yuan spot rate needs to crawl. But, China cannot move the yuan up abruptly, because this would kill revaluation expectation and trigger capital outflow.
I believe that the yuan spot rate will inch by 2% this year; 3% is possible but not likely. This sort of creeping would be consistent with China’s stability. |
