timothy taylor, managing editor of The Journal of Economic Perspectives, published by the American Economic Association, writes the “Conversable Economist” blog at conversableeconomist.blogspot.com.
Published May 4, 2020
When you think of China, images of R95 face masks, deserted streets and makeshift hospitals no doubt come to mind. But coronavirus notwithstanding, the dominant reality of contemporary China is its formidable economic footprint on the global economy — and its legendary trade surplus, in particular.
We all know that China’s economic success depends on running gigantic trade surpluses. Well, not any more. China’s surplus has been small relative to the size of its economy for a decade and has been approaching zero in the past few years. Indeed, a November 2019 working paper from the International Monetary Fund pre-dicted that China would begin to run a small current account trade deficit in coming years.
Here I’ll explain why China’s trade surpluses mushroomed in size from 2001 to 2007, but then quickly slipped back to pre- 2001 levels. The chronology offers some insight into the fundamental drivers of trade balances (in China or any other economy) and why China’s trade balance is now headed toward deficit. I’ll also opine on what this shift is likely to mean for the ongoing U.S.- China trade war — and for the world economy.
In the Beginning
During China’s first decade of rapid growth, as it was shedding Maoism in the 1980s, the economy ran a current account deficit that averaged less than 1 percent of GDP per year. Even during China’s second decade of rapid growth, the economy averaged a moderate current account surplus of 1.7 percent.
But when China joined the World Trade Organization in 2001, the walls that had been limiting China’s trade came tumbling down.
Exports of goods and services spiked from 20 percent of GDP in 2001 to 36 percent in 2007. China’s imports climbed from 18 percent of GDP in 2001 to 28 percent in the same period. In other words, China’s economy became thoroughly intertwined with the global economy in just a few years.
This was textbook “export-led” growth that paralleled the earlier successes of Japan and South Korea. China’s exports had grown faster than its economy from 1980, rising from 6 percent of GDP in 1980 to 20 percent of GDP in 2001. Up to 2001, the rise in China’s imports had mostly kept pace. But after 2001, the current account surplus ballooned to an astonishing 10 percent of GDP in 2007.
The speed and magnitude of these changes were not expected by the Chinese or anyone else. China’s own 10th five-year plan covering the years 2001 to 2005 did not forecast this seismic shift. But the dramatic imbalance quickly righted itself. By 2011, China’s current account surplus was back to 1.8 percent of GDP, where it had been in 2000 — and it stayed near that level before edging closer to zero in the past few years. China’s exports and imports as a share of GDP have now moved back to where they were in 2001, as well. In this sense, China’s current economy is less intertwined with the global economy than it was back in 2007.
The main events triggering the trade roller coaster are clear. As noted above, China’s surplus rocketed up when China entered the World Trade Organization in 2001 because its exports increased faster than its imports. The subsequent fall coincided with the arrival of the Great Recession, which slashed demand for China’s exports around the globe. Although China was certainly affected by the Great Recession, its economy didn’t suffer as deeply or as long as many others, so its own imports did not sag as much. It’s worth noting, too, that China had kept the exchange rate of the renminbi fixed between 1995 and 2005. But, under pressure from its trade partners, it allowed its currency to appreciate — which also tended to make China’s imports cheaper and its exports more expensive.
Nothing in this history involves canny Chinese trade negotiators hornswoggling their U.S. counterparts. No analyst worth taking seriously even tries to argue that China’s trade surplus shot up to 10 percent in 2007 because China enacted rules or tariffs that pinched imports (remember, China’s imports were also rising sharply at this time), or because of subsidies to state-owned companies, or because of Beijing’s failure to curb abuses of international intellectual property rights. By the same token, no one seriously makes a case that China’s trade surplus plunged back to 1.8 percent of GDP in 2011 because Beijing bowed to pressure to open its markets to imports, or to protect the intellectual property of foreign firms, or to reduce subsidies to state-owned firms.
Economics with Tears
As you probably learned in Econ 101 (and may have forgotten because it seemed to defy common sense), trade balances are largely determined by big macroeconomic forces that have little to do with how sneaky exporters are or how sly governments are in favoring their own producers. Those macro forces are what led to China’s humungous surplus in the early 2000s and the about-face thereafter.
Let’s take a brief trip down memory lane to that much-beloved Intro to Economics class. If a country has no trade at all, then domestic production will, by definition, be equal to the total of domestic consumption and domestic investment — everything that’s produced ends up somewhere, and even unsold inventory counts as investment. If a country’s trade is balanced, it will still be true that domestic production is equal to domestic consumption and investment, because any production that is exported is exactly offset by imports. That’s just arithmetic.
During the past decade or so, China has been shifting toward an economy in which demand is driven less by export markets and more by its own domestic demand — a transition sometimes called “rebalancing.”
What about a country with a trade surplus, like China? When exports exceed imports, domestic production must exceed the sum of domestic consumption and investment. And, of course, an economy with a trade deficit, like the United States, must be consuming and investing more than it produces.
Ponder the implications. Countries with trade surpluses — which must mean that domestic production exceeds domestic consumption and investment combined — tend to have high rates of saving, with the spillover used to make foreign investments. Conversely, countries with trade deficits tend to have low rates of national saving and to receive inflows of foreign capital to cover investments. In the case of China and the United States, China used a substantial share of the revenues from its trade surpluses to purchase (that is, to invest in) U.S. Treasury debt. The country with the trade surplus experiences an outflow of financial capital, while the country with a trade deficit has a corresponding inflow of financial capital.
With this background in mind, we can begin to see what caused China’s trade deficit to take off from 2001 to 2007. Start by imagining a scenario that did not quite happen. After China enters the World Trade Organization in 2001, exports surge dramatically for China’s firms. However, let’s say in this imagined scenario that all of the revenues and profits from those additional sales are passed along to workers (in the form of higher wages) and to owners of firms (in terms of dividends). In this scenario, higher exports for China are accompanied by more consumption — including consumption of imports. And as China’s exports and imports rise in tandem, China’s trade balance remains the same.
Something like this scenario did happen, in part. Wages in China did rise dramatically in the years after 2001, and at a blistering annual rate of more than 13 percent. By no coincidence, China’s imports also rose very quickly in the early 2000s, as both consumers and producers went on foreign shopping sprees. But firms in China were not operating in an economy with sufficient pressure from labor and corporate financial markets to be forced to pay out all of the additional profits they were earning. As a result, saving in China’s corporate sector (i.e., retained earnings) increased rapidly from 2001 to 2007.
In short, China’s firms in the years after 2001 were not cycling all of the revenue from their increased exports back into China’s economy, where it could be used for greater consumption, including consumption of imports. Moreover, the savings rate for China’s households remained sky high. And this is the key to why China’s production of exports rose so much faster than its consumption of imports in the years after 2001 — and thus why China’s trade surpluses shot up to 10 percent of GDP in 2007.
Looking ahead, these underlying macro forces, including broad shifts in the operation of global markets and the evolution of national savings rates, help to explain why China’s trade surpluses have since declined to less than 1 percent of GDP and may turn negative in the next few years. During the past decade or so, China has been shifting toward an economy in which demand is driven less by export markets and more by its own domestic demand — a transition sometimes called “rebalancing.”
In the years after 2007, China’s exports were growing more slowly than GDP — or, to put it another way, exports were no longer leading China’s growth. Indeed, China’s economy has become so large (and the global political climate toward trade so hostile) that it has become difficult to imagine China again using exports as a primary driver of growth. The rates of savings by China’s firms have declined, meaning that more of their revenues are being cycled into the rest of China’s economy.
On the flip side, demand from consumers has been on the rise. One example: as anyone who lined up to visit the Tower of London or the Louvre last summer knows, one substantial change in China’s trade picture is a sharp increase in Chinese foreign tourism — which counts in the trade stats as China importing foreign services. (That travel has collapsed, of course, thanks to coronavirus. But there’s little doubt it will come back quickly.)
As part of China’s rebalancing of demand toward domestic consumption, even China’s famously high household savings rate — at 23 percent of GDP, 15 percentage points higher than the global average — seems likely to trend down. One main reason for China’s high rate of household savings has been that China has only a sketchy and poorly financed system for pensions and health care for the elderly. Add to this the reality that one unintended consequence of China’s one-child policy (only abandoned in 2015) is that the elderly will not be able to rely on younger generations for support. After all, the one-child policy means that four grandparents will have, at most, one grandchild between them.
But China’s population is aging, and the generation of older people who have been saving at a breakneck pace will be shifting toward more spending as retirees. China’s working- age population peaked about five years ago, and the total population seems likely to peak in the next few years. Births in China have been falling; in fact, the 14.6 million babies born in 2019 was the lowest number since 1961.
More detailed analyses suggest that while China is likely to increase imports of items like electronics from nearby Asian producers, the U.S. may have the advantage in exporting to China in service-related areas like finance. These projected trends, combined with a lower savings rate by aging households, are what drive the predictions that China’s small trade surpluses could even become deficits in the medium term.
As China’s rate of savings declines and its consumption rises — including consumption of imports — China’s current and near-term trade surpluses have dropped to less than 1 percent of GDP
What implications do these great macroeconomic and demographic shifts have for the U.S.-China trade wars? When President Trump first became specific about his plans for imposing tariffs on China in March 2018, the primary rationale was that the policy would reduce U.S. trade deficits. The “Phase I” agreement announced in January 2020 had two main methods of accomplishing this goal. First, China agreed to purchase an additional $200 billion in U.S. products in specific categories in the next two years. Second, the agreement included provisions aimed at China’s treatment of intellectual property, foreign investment, U.S. exports of agricultural products and financial services. But for a combination of economic and political reasons, there’s less here than meets the eye.
For example, China’s promise to increase imports of specific U.S. products may well prove unworkable without active intervention. China’s government could pressure its firms to purchase more from U.S. firms in the designated categories, but do nothing to prevent them from buying less in the categories not covered in the agreement — in which case, overall U.S. exports to China might not change much. Or China’s government might require firms, say, to buy soybeans from the U.S. rather than from Brazil and Canada, which would be unfortunate to the degree that Washington cares about its relations with Brasilia and Ottawa.
The Phase I trade agreements are clearly political documents. Notably, the success of the $200 billion purchase commitment will not be possible to evaluate from trade statistics until after the November 2020 election. In other areas, like rules to liberalize China’s imports of financial services, most of China’s “concessions” consist of provisions that had already been adopted long before the agreement was announced. Likewise, China’s promises to protect intellectual property are similar to promises made to the Obama administration several years ago.
A $200 Billion Misunderstanding
There’s a much bigger misunderstanding about U.S. interests in the confrontation with China. The White House has taken the big bilateral U.S. trade deficit in goods as evidence of China’s perfidy. But almost all economists believe that bilateral trade deficits fall somewhere on the spectrum between hard to interpret and meaningless. After all, the United States also runs a bilateral trade surplus in services with China of about $40 billion per year — which we in the United States, at least, do not regard as evidence of unfair U.S. trade practices.
In fact, the U.S. has merchandise trade surpluses with a host of countries. For example, the U.S. bilateral surplus in merchandise trade exceeded $10 billion in 2017 with Singapore, Hong Kong, Belgium, Australia, the Netherlands and the United Arab Emirates. These surpluses hardly mean that that the U.S. is trading unfairly with, say, the UAE. It just means that the UAE’s exports (almost entirely oil and refined oil products) are fungible, and it makes more sense to sell the fuel to Europe and Asia than to North America.
Similarly, China has a large bilateral surplus with the U.S., even though China’s overall balance of trade is near zero. To put it another way, almost all of China’s surplus with the U.S. is being counterbalanced with bilateral trade deficits that China runs with other countries. In a global economy, there is no reason to expect (or to wish) every country to balance trade individually with every other.
Another difficulty in interpreting bilateral trade balances arises because a large and increasing portion of goods crosses more than one international border before being sold as finished goods. A common example: each Apple iPhone 7 exported from China to the U.S. counted as $225 (the manufacturing cost) in the trade statistics a couple years ago. However, only about $5 of that value was added by assembly and testing in China; the rest came from iPhone components that had been imported into China. Bilateral trade statistics seem to show the U.S. importing iPhones from China, but the global stats show that the U.S. is actually importing almost all of their value from other countries — it’s just that China is the final point of departure for iPhones coming to the U.S. economy.
If U.S. policymakers want to blame trade deficits on countries with corresponding trade surpluses, then China with its trade surplus heading toward zero is an unlikely culprit. Contrast China with Germany, which ran a current account surplus exceeding 7 percent of GDP in 2019.
If U.S. policymakers want to blame trade deficits on countries with corresponding trade surpluses, then China with its trade surplus heading toward zero is an unlikely culprit.
Even if China fulfills its promise to purchase $200 billion of additional U.S. exports in the next couple of years, that seems unlikely to have much effect on the overall U.S. current account deficit, which was about $500 billion in 2019. The fundamental reason behind the large U.S. trade deficit — and behind the long string of U.S. trade deficits in the past few decades — is that the U.S. is a high-consumption, low-saving economy. As noted above, it consumes more than it produces, and it manages that trick by consuming imports with a greater value than U.S. exports. The U.S. economy pays for the difference by borrowing abroad — for example, in the form of sales of U.S. Treasury securities — or by selling assets like real estate.
As a result, attempts to redirect the flows that comprise international trade can rearrange the proverbial dance partners, but still have next to no effect on the overall balance of trade. The latter turns on macro forces such as national rates of savings and economic growth. Indeed, at least for the first half of 2020 and perhaps longer, the coronavirus outbreak is likely to have a larger effect on China’s exports and imports than U.S.- China trade negotiations.
Wheels Within Wheels
Perhaps January’s Phase I trade agreement with China, and any phases that follow, will surprise me in pleasant ways. For example, when China developed its bad habit of ignoring the intellectual property rights of foreign firms several decades ago, its economy was small enough that the bad behavior had little macroeconomic effect. But China’s GDP is now 30 times larger than it was in 1980, and five times larger than it was as recently as 2000. It would be a fine thing for China to start respecting the patents, copyrights and trade secrets of others, the way they expect others to respect their own intellectual property. But this goal seems to receive little more than lip service in the trade negotiations for either the U.S. or China.
As the U.S.-China trade war diesels ahead, China’s shift to a near-zero balance of trade will have subtle but meaningful effects on the global economy. For example, the very low global interest rates of the past few years have been driven in part by the high supply of savings. As saving declines in China, what former Fed chair Ben Bernanke called the “global savings glut” will diminish, too. One notable consequence is likely to be less demand for U.S. Treasury securities at bargain interest rates — an unwelcome reality when the U.S. budget deficit, financed by selling Treasuries, exceeds $1 trillion even in a time of full employment.
Moreover, while China is an extreme example of a rapidly aging society — the unavoidable long-term legacy of its stark one-child policy — most of the rest of the world is aging as well. The share of global population over age 65 was 6 percent in 1990, 9 percent in 2019 and is projected to reach 16 percent by 2050. As the world gets grayer, global rates of saving are likely to decline. In this sense, China’s shift to a near-zero balance of trade — and perhaps even a pattern of modest trade deficits in the future — is just one consequence of the tectonic shift toward an aging world population.