China’s 2020 external surplus - a wake-up call

In 2020, China drove macroeconomic imbalances. If the rest of the world is to develop a sustainable approach to economic interactions with China, it is critical to understand why, argues François Chimits.

The are many reasons why the year 2020 will stand out in our memories. One that may not yet be obvious to many, is that China returned to a level of macroeconomic surplus not seen for decades and, in the process, is likely to have hoovered up some 330 billion USD over the year.

Although some cyclical factors played a part, the situation reminds us that trade barriers are not an effective means to tackle such macroeconomic imbalances, and that China still has quite some work to do to rebalance its economy towards consumption and to live up to the transparency standards on exchange rate and foreign exchange (FX) reserves. 

Current account – the imbalance that matters

When public conversations refer to a trade deficit, what they are often actually talking about is the current account balance. The current account (CA) is part of the balance of payment – a national account book of all economic interactions between a country and the outside world, covering all flows of goods, services, primary income, and secondary income between residents and nonresidents.

China to date has largely followed an export-oriented development model, similar to that of other East Asian growth miracles that have experienced a sustained current account surplus before eventually levelling off as growth in wages and consumption outpaces GDP growth and rebalances the economic structure towards domestic consumption.

Merely looking at the current account would have led you to think China was on a similar trajectory, at least until 2019. The International Monetary Fund (IMF), in charge among other things of monitoring external imbalances, seemingly shared that view. It has praised China’s efforts to rebalance towards domestic demand and forecasted in late 2018 a trend for a balance by 2025.

The China surplus is back, unexpected and big

However, the figures so far released for 2020 look very different to the IMF forecast, trending towards a current account surplus of 330 billion USD. That amounts to 2.2 percent of Chinese GDP and 0.5 percent of the rest of the world global GDP.

What this means is that, on a purely accounting basis, while foreign demand spurred Chinese GDP in 2020, Chinese demand dragged economic activity in the rest of the world.

You could say that, with the Covid-19 pandemic, 2020 is not a year from which to draw structural conclusions, particularly since China has been ahead of most large economies in navigating the situation. But according to prevailing wisdom, this should have reduced China’s surplus as the measures taken to counter the spread of the virus around the world weighed more on consumption than production. With Chinese citizens able to get back to near normal life much sooner than others, this should have driven consumption and imports up, while exports should have suffered from depressed foreign demand. But, as we have seen, the opposite has been the case.

Some of the explanatory factors for this surplus relate to the health crisis. The pandemic has led to a distortion in global demand away from leisure, tourism and commodities, which China imports in huge quantities, towards medical products, IT and home equipment, which China exports. Indeed, the growth of exports of Chinese goods (+4% over 2020, +17% in Q4 2020 YoY) can be explained almost entirely by the increase of those three categories of products. Meanwhile, the drop in the price of fuel has led to the value of mineral fuel imports falling by 72 billion USD, while China’s deficit on service trade was reduced by 40 percent YoY from January to September thanks to a 92 billion USD fall in tourism “imports” (Chinese tourists spending abroad).

Underlying issues

But beyond these pandemic-related factors, the surplus points to worrying structural issues – it reveals the Chinese economy’s bias against consumption and its opaque management of the exchange rate.

China’s economic recovery following the Covid crisis was led by production and investment. Industrial output and investment recovered fairly quickly, both running at plus three percent in 2020, while consumption suffered a two percent drop. This likely reflects precautionary savings and a drop in household income growth. Both are fueled by the shortcomings of the Chinese social safety net, especially in the case of internal migrants who receive little social security, work under precarious contracts, and lack freedom of association.

Although the Chinese leadership has recently sent another strong signal that it wants a new push for domestic consumption, it remains to be seen how they intend to increase the bargaining power of low-skilled labor.

The situation has also shed light on the opacity of China’s exchange rate and foreign reserves management. The market response to such a large current account surplus would be a strong appreciation of the currency or a significant increase in the net financial outflows from the country running the surplus. But in China’s case, financial inflows in 2020 were large, thanks to greater market and financial opening as well as outperforming the rest of the world in terms of growth.

Yet the RMB has only moderately appreciated compared to 2019 once corrected from the steep USD depreciation. In 2020 the RMB gained +6.5 percent against the USD. The Chinese authorities’ efforts to slow the appreciation of the RMB should have become evident in increasing FX reserves. But China’s reserves have remained broadly stable throughout 2020 once valuation effects are excluded. It appears that the current account surplus and the financial inflows have been recycled in external banks loans and foreign currency deposits, apparently driven by the four large state-owned banks.

It looks very much like non-market forces are at play, i.e., that mandated banks have accumulated reserves to push down the RMB exchange rate. The jump in “other source” funds and “other assets” on the PBoC’s balance sheet by 700 billion RMB, in late 2020, has only increased such speculation.

The search for a new approach

This last year has raised more questions than answers about whether China can be a responsible stakeholder in our globalized world. The US approach of using tariffs and sanctions has failed to prevent the macro imbalances from worsening. Nor has the IMF’s more positive engagement approach, with recommendations and the elevation of the RMB to de facto reserve currency helped.

As for the EU, confronted with the reality that Chinese imbalances and exchange rate opacity have never really gone away, it has yet to present an approach that can effectively tackle these problems. In contrast to more trade-related, level-playing-field challenges, where the EU Commission is displaying an ambitious agenda, there is no sign that it is addressing this pressing issue.