I wanted to write a follow up to my previous post about whether China has a trade surplus because I received a number of very good questions and I felt there were some confusion about the implications of what I was trying to say. Let me emphasize that in some areas here my thinking is still fluid and there are good arguments are both sides, so I won’t say that my thinking is final by any means.
- This is not misinvoicing. This is related to misinvoicing in that it achieves the same ultimate objective of disguising capital flows but it is not misinvoicing. Misinvoicing is the process where a $100 export from Hong Kong to China turns into a customs reported $200 Chinese import from Hong Kong. This is a mis-payment scheme. In this case, Hong Kong reports a $100 export to China, China reports a $100 import from Hong Kong. However, now when the Chinese importer goes to the bank to pay the Hong Kong exporter, the importer tells the bank to pay $200 rather than the $100 reported to Customs. This may happen by the importer presenting forged Customs documentation to the bank or by bribing bank officials. This may seem like a semantical difference but it is important to understand the difference and I will explain why the difference matters a little later.
- There has been some confusion about whether I am arguing whether this means China has a real trade surplus or whether imports are actually higher than reported. I think it is highly unlikely that that other countries are exporting to China $2.7 trillion worth of goods but Chinese customs is only reporting $1.7. The reason is simple: that discrepancy would easily be caught by comparing Hong Kong/Australian/German/Japanese/US exports to China and Chinese imports of Hong Kong/Australian/German/Japanese/US products. We do not see that discrepancy. This means that that the value of physical goods imported in China is most likely $1.5-1.7 trillion. I have dealt with Chinese data and nuances long enough to never rule anything out, however, it seems unlikely that China is actually importing $2.7 trillion worth of goods.
- However, we need to be careful about immediately jumping to the conclusion then that China has a real trade surplus. Though it may be fair that the market value of the goods trade would have resulted in a surplus, net exports for national accounting purposes are not based upon physical output or a market value but essentially on a cash basis. For instance, if physical oil exports rise 10% from 100 to 110 but the price of oil drops from $100 to $50 then the cash value of exports drops from $10,000 to $5,500 for a 45% drop. The “real” increase in export shipments is irrelevant in some ways. It helps inform our understanding of the whole but for national income accounting with regards to net exports (X-M) is irrelevant. In real terms yes I think it is fair to say continues to have a trade surplus, but in very real ways this does not mean anything as cash is how trade balances are calculated and pass through to GDP growth. In other words, people no longer trade seashells but cash and on a cash basis, China does not have a trade surplus.
- My thinking on what this means for GDP growth is more fluid and I would appreciate comments from someone who is a true national income accounting expert. I lean towards the argument that this has direct and negative pass through effect on the GDP growth and let me explain how. In nominal terms, Chinese official data says GDP was 67.67 trillion RMB at the end of 2015 compared to 63.59 trillion RMB in 2014 for total nominal growth 4.08 trillion RMB. Now the nominal RMB Customs reported trade surplus was 3.69 trillion RMB. Now if reverse the Customs reported trade surplus and account for the trade balance on a cash basis including the service deficit, this turns into a trade in goods and services (emphasis not current account) deficit of 226 billion RMB. This means that nominal growth when using the cash basis net export trade deficit turns into nominal growth of only 168 billion RMB or less than 0.3% in 2015. I should strongly emphasize that I am implicitly assuming that China is counting net exports as equal to the trade balance reported at customs as part of the old equation Y = C + I + G + NX. Now here is the primary reason I believe this has a negative impact on growth and that growth should be reported, and again my thinking is fluid here. Running a trade surplus implies that there is surplus cash flowing into the economy. This cash is creating additional savings, investment, jobs, and demand throughout the economy. However, because there is no surplus cash there is no additional savings, investment, jobs, and demand. In fact, we see the impact pretty clearly. When trade surpluses were high and the PBOC was sterilizing, China was awash with cash and investment was booming. Now Customs reported trade surpluses are at record highs, but liquidity is tight and rather than sterilizing the PBOC is propping up the RMB. Furthermore, as previous noted, because NX are always thought of on a cash/nominal basis, it seems that the impact on growth needs to be considered on a cash/nominal basis rather than a real basis. Before I published my original post, I consulted a couple of very knowledgeable people about some of the implications like this and they all came back to me and said they really didn’t know and would have to think about it. I say this definitely not to blame anyone I consulted as all errors are mine, but rather to note that this is a thorny issue about the implications and that this is what I currently think about the implications for growth but I am open to changing my mind and these are not deeply held convictions.
- This is also why capital controls would not work. For all the chatter about China imposing capital controls, it is obvious they simply wouldn’t work. Let me explain. Impose the most draconian capital controls you could imagine and money would still flood out of China via the free currency transactions via the current account. I can already hear people saying, just tighten capital flows on the current account side. The only way that could be achieved is by bringing goods and services flows into and out of China to a near standstill. Think I am exaggerating? Imagine customs inspectors having to count every physical unit into and out of China; establish an independent market price for every good and service into and out of China; verify the agreement between importer and exporter is at the independent market price; follow the importer exporter to the bank to verify that the payment or receipt perfectly matches the customs approved value. In other words, at every possible step for every unit, everything would have to be verified and approved by the government. This would necessitate bringing goods and services trade into and out of China to a complete standstill.
- Finally, I think there are a couple of things driving this shift in flows. First, China opened up the current account in 2012 to relatively free currency transactions and the data shows this discrepancy began growing rapidly in 2012. That should not come as any surprise. Second, in late 2012 and early 2013, China had a power hand over and it is likely that a not insignificant part of this outflow is driven by security concerns. Chinese brokerages who survey their clients regularly find that high net worth individuals are concerned about a variety of issues with large numbers of them looking to leave China. Third, investment returns in China have been declining for about 18 months. For instance, 10 year local government Chinese debt is lower yielding than good quality US corporate debt. Given the junk/near junk status of local government offerings, the risk return there is easily worth examining closer shall we say. Fourth, I don’t think this is temporary in the least or about the stop or reverse. This has been picking up speed since 2012 and shows no sign or reason to stop. Outward FDI or official capital flows have no reason to use this channel. This should be thought of as long term or permanent removal of capital from China. Whether someone is moving from China to Canada or a small to medium size business is expanding elsewhere, most companies have no reason to use this channel. This is not short term opportunism but rather long term to permanent capital expatriation. Yet another reason, capital controls are very unlikely to work.
- I apologize if I missed any issues as I tried to cover them.