Houze Song
For 25 years, China has been running a current account surplus, and the world grew accustomed to “China the exporter” of last resort. So when The Economist recently made the case that China would soon become a current account deficit country, eyebrows were raised. The implications of the end of such an era are significant, piquing market interest and engendering debate.
That debate has centered on the relationship between savings and investment, since a country’s trade balance is simply the difference between the two. So what happens to China’s trade balance depends entirely on whether savings or investment declines faster.
On the one hand, economists have emphasized the impact of China’s declining savings rate on its trade balance. They argue that as savings continue to dwindle, a current account deficit will become a permanent feature of the Chinese economy.
On the other, observers believe a sudden drop in China’s high investment rate should be a pressing concern. They argue that should Beijing stop stimulating domestic investment, its collapse would lead to a spike in China’s trade surplus at a time of weak global demand. Since there won’t be sufficient demand to absorb China’s surplus, it will likely crowd out demand elsewhere and potentially jumpstart a global recession.
Both arguments have some merit, but they are also flawed. Here I’ll first make the case for why a collapse of domestic investment is unlikely and therefore will have little impact on the trade balance. Then Part 2 will examine the declining savings issue and provide my outlook on China’s trade balance.
Financial Resilience
The International Monetary Fund (IMF) has put China’s excessive investment—meaning the returns cannot cover the costs—at around 10% of GDP. Assuming these loss-making investments are only worth 25% of the cost and are all financed by borrowing, that would reduce China’s GDP by 7.5%, with creditors facing an equivalent amount of losses.
Such a situation certainly seems untenable. The estimates above imply that China’s banking sector would become insolvent after just two years of over-investment (Chinese banks’ total equity is only about 15% of GDP based on market valuation).
But they are not insolvent. So what gives?
One main reason is that the cost of over-investment is not concentrated in the banking system but distributed among two key borrowers: local government financing vehicles (LGFVs) and state-owned enterprises (SOEs), which together constitute nearly all of the excessive investment. Both of these borrowers have alternative sources of funding, namely land sales and state subsidies.
First, LGFVs are controlled by local governments that have access to land, with annual income from land sales equal to at least 2% of GDP (assuming gross land sale is 5% of GDP and net income is 40% of gross sales). Second, based on flow of funds data, the Chinese government has been subsidizing SOE investments by around 1% of GDP annually for the past decade.
Additionally, it is common practice for state banks to use their profits to cross-subsidize bad loans. On average, financial sector profit has been around 3% of GDP, and more than 90% of the profit has been recycled to absorb bad loans.(In contrast, US banks usually pay out around 30% of their profits as dividends.) Accounting for these factors, China’s annual net loss from over-investment is reduced from 10% to around 2% of GDP, a much more manageable figure.
Still, more manageable excessive investment does not indicate economic health. The perennial existence of such investments means that China still has to absorb waste and welfare loss. In theory, Beijing should unwind this wasteful practice. But in reality, it won’t happen anytime soon.
Institutional Stickiness
That’s because the main source of this excessive investment is the state sector (LGFVs are just SOEs by another name). So to the extent that the state sector doesn’t shrink or improve efficiency, over-investment will continue to be a fixture of the Chinese economy. To curtail excessive investment, the state sector needs to be meaningfully reformed.
But the track record of SOE reforms does not instill confidence. Basically, SOE performance peaked around the early 2000s—when Premier Zhu Rongji forced through major reforms—and has since remained more or less stagnant. Today, SOEs’ return on assets has regressed back to their late 1990s levels, while their total assets as a percentage of GDP has surpassed its previous peak (see Figure 1). This is exactly the “big but weak” problem that Beijing has long identified and has sought to remedy.
Figure 1. State Sector Is Bigger but Weaker
Source: Wind.
Blaming SOE under performance on the 2008 stimulus has become fashionable, but I believe other factors are at play.
First is SOE corporate governance, which has prioritized government control at the expense of operating efficiency. Given the haphazard governance reforms on the table, SOE efficiency will improve only marginally, if at all. This means state firms will continue to rely on external financing for investments and operations in the foreseeable future.
Second, previous reforms failed to limit the ease with which the state can gain control of valuable economic opportunities and resources. The state has largely played musical chairs: when it was forced to exit certain sectors, it simply moved into other emerging sectors. Rather than weakening the state, this unshakeable pattern has instead entrenched SOEs.
As long as Beijing’s policies reinforce the institutional stickiness of SOEs, then excessive investment will remain a symptom of state sector inefficiency. In this environment, concern over the impact of investment collapse on China’s trade balance seems misplaced. Figuring out how to solve the resilience of over-investment would be a more productive preoccupation.
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