Yawning Bread. November 2007

China's trade surpluses: disequilibrium and accommodation




It's the European Union, not the United States, that is China's largest trade partner. The Sino-EU trade balance is just as unbalanced as the Sino-US one, even though the latter might have been more politicised.

In 2006, China's exports to EU reached US$181.98 billion, a rise of 26.6 percent year-on-year, according to the Chinese Ministry of Commerce. Imports from the EU totalled US$90.32 billion, an increase of 22.7 percent from the previous year. [1]

Euro and Yuan

The gap between exports and imports is stunning. In 2006, it was US$91 billion, with China exporting twice as much to Europe as it imported from there. For 2007, the trade gap is likely to widen to US$235 billion (Euro 160 billion).[2]

Clearly, this is not a sustainable situation. This is not to say that bilateral trade between countries must always be balanced, but when such huge amounts are involved, any imbalance must be extremely difficult to make up from trade with other countries.

Huge foreign reserves

Years of trade surpluses have led to the Chinese holding a lot of US Treasury Bonds among its US$1.3 trillion worth of foreign reserves. China has been among the top buyers for years, though market observers have noted a trend starting in the middle of this year with the Chinese scaling back their purchases.

That should hardly come as a surprise. The falling US Dollar has made it rather silly to keep one's foreign reserves in that currency, yet by being among the largest holders of US Treasury debt, it was impossible for China to get out of it in any significant way without causing a stampede. Untying this knotty problem is going to take many years, and even then, the chances of doing so smoothly aren't bright.

If China is seen to be abandoning the US Dollar, the latter currency will go into a free fall. Americans will find imports prohibitively expensive and the economy will stutter. This will have knock-on effects on plenty of manufacturers and service providers around the world who depend on selling to the American market, including the Chinese ones. An American recession will ripple across the globe.

It is likely also to severely undermine banks. As the problem in the subprime mortgage market is showing, many banks around the world hold US Dollar-denominated assets. As these are written down, banks can be severely weakened leading to banking and liquidity crises.

Yet if the Chinese do not do something about their vast holdings of US Treasury debt, the steady decline of that currency must surely erode the value of China's foreign reserves.

I wonder if history's verdict might be that the Chinese were foolish to rake in so much in trade surpluses. History has already judged the Americans, courtesy of the Bush administration, foolish in running up such a huge current account deficit -- it was a record US$857 billion in 2006. [3]

Yet what else could the Chinese have done? Beijing needed to lift the country out of poverty, the world was knocking on Chinese manufacturers' doors, so why not export as much as possible?

China needs a bigger domestic growth engine

The bias towards export-led growth has a historical explanation. It made sense when foreign investment and foreign exchange was badly needed in the early days of China's opening up. Foreigners had the funds and the technological know how, and Western countries were the most attractive markets. The 1980s' Special Economic Zones (SEZ) that Deng Xiaoping promoted to attract such investments made sense.

But at some point, the line was crossed when China started making far more in foreign trade surpluses than it knew what to do with. In a metaphorical sense, the whole Eastern seaboard is now one big SEZ. These surpluses had to be parked abroad; repatriating them into Yuan would cause uncontrollable domestic inflation since China does not have a true floating exchange rate.

By this stage, China should not still be so reliant on export-led growth. The countless multitude of small manufacturers would surely be happy to sell to whoever would buy, including domestic customers. The problem may be that China has been too slow to free up its domestic market. Administrative obstacles, corruption, poor infrastructure and an unresponsive banking system make it more difficult for domestic producers to target the domestic market than should be.

While things are improving and China's economy now has a strong domestic engine, nevertheless an uncomfortably large part, especially employment, is dependent on export demand. This means the Yuan cannot be delinked from the US Dollar anytime soon, yet without a significant revaluation of the Yuan, it means the Sino-US trade imbalance will continue.

But what to do with the profits?

I suppose, theoretically, rather than letting the foreign exchange surpluses pile up, China should have used them to improve its own economy and the living standards of its people. The government could have been more aggressive in buying improvements to ports, railways, telecommunications, and investing too in education, healthcare and housing. However, I concede I cannot quite imagine how one can use foreign exchange to improve education and healthcare domestically -- surely these are highly dependent on trained local human resources. I would also add that China could have invested heavily in energy efficiency and environmental protection, including research into these fields. These 2 areas must be tackled before they become major impediments to further growth soon.

China's construction boom never lets up

No doubt, all the above is easier said than done. Carrying out such ambitious designs requires technical and management capabilities that China's political class may not have. In any case, there are already severe bottlenecks from an overheated economy, growing at 11 percent a year; adding more projects will only make things worse. Already, China's inflation rate is in the region of 6.5 percent this year.

But continuing on this path is also untenable. The Europeans are going to get angry; the Americans still aren't mollified despite their devaluing Dollar (because the Yuan more or less follows it down).


To be a responsible partner in the world economy, the Chinese need to do a serious rethink of their role in it. They are well past the point where accumulating more foreign reserves through export-led growth will do them any good.

They have to contemplate a steady revaluation of the Yuan. No doubt this causes Chinese central bankers sleepless nights. I suspect the problem lies in the fact that there are two Chinas. The coastal regions, with better developed markets and companies able to invest in technology to improve productivity may be able to absorb a gradual currency revaluation, but the hinterlands are still very poor. There is a lot of underemployment, poor infrastructure and low technology, and it would be a cruel outcome if China's export and wealth-creating engine is jeopardised by a revaluation before development has trickled into the inland provinces.

Perhaps some mild revaluation may be able to finesse the difference, though even then, there will be some degree of employment losses as export manufacturers become less competitive

Tax changes can help induce the manufacturers to relocate inland where labour is still cheap even with a revalued Yuan, though massive improvements in transport infrastructure will be needed to ship the goods out efficiently. The unemployment risk can also be addressed by focussing on the services sector. For one thing, China needs a massive expansion and upgrade of the now-collapsing national healthcare system.

At the same time, the government must do a lot more for education, for there is no social time bomb more dangerous than a people shut out of a modernising economy because of poor education, yet see others get rich.

Sovereign wealth fund

Those reserves the country already has (and will no doubt continue to acquire) need to be put to better use before they lose their value. Earlier this year, China set up its sovereign wealth fund with the aim of taking up stakes in companies with good returns. Its seed money alone is reported to be a whopping US$300 billion.

Sooner or later, given the way the Americans tend to see China as a strategic threat, the US Congress will get hysterical about an intended purchase, especially if an iconic company with cutting edge technology or dominant position in the American market is involved. Congress' tendency needs to be reined in, otherwise more conflict will occur.

The fact is, after 2 decades of fast-paced growth, China is coming into its own as a middle-income economic power and a major player in the world economy. A strategic realignment of economic power is called for, which must be hard for the US to stomach. Yet, whether through revaluation of the Yuan (the US' preferred solution) or fast accumulating surpluses from a cheap Yuan (possibly China's preferred solution), China will have huge buying power. The US and the EU cannot frustrate that new reality and still expect all to be well.

Yawning Bread 



  1. Source: China Daily, 28 Jan 2007, http://www.chinadaily.com.cn/china/2007-01/28/content_794665.htm 
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  2. Source: Straits Times, 29 Nov 2007, China vows to address EU's yuan concerns
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  3. Source: Attributed to US Commerce Dept. link   
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