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The Art of Balance

The sharp reduction in China’s current account surplus over recent years has ignited a flurry of speculation about whether the world’s second largest economy has achieved the fundamental, economic rebalancing which many have been pressing for.  That is, rebalancing in terms of reduced dependence on exports, and increasing reliance on the domestic market by boosting consumer demand.

My own opinion is that it is too early to say.  True, China's current account surplus fell to around 2.8 percent of gross domestic product in 2011, from a pre-crisis peak of more than 10 percent in 2007.  And while the reduction in China’s current account surplus is welcome news, we remain concerned that these changes may not represent a sustained, downward trend.

One possible sign of a durable turnaround in China’s current account surplus would be a pickup in consumption growth but there is little evidence that consumption is rising as a share of GDP.

But then if the rebalancing is not driven by greater domestic consumption, what might be the other forces behind the decline in China’s current account surplus?

Cyclical forces have played a role.  Since 2008, growth and demand has been severely damaged by the global financial crisis.

The impact on China’s export sector is obvious: for example, exports of machinery and equipment to the United States contributed 10-15 percent of China’s overall export growth in the early 200s.  This figure is now around 5 percent.

Simultaneously, the higher demand for imported minerals and energy was a result of China’s huge, infrastructure-driven stimulus against the global recession, funded by massive injections of new credit.

Worsening terms of trade

Yes,  more lasting forces did contribute to the reduction in China’s trade surplus.  Strong Chinese demand for commodities and minerals--which contributed to rising global prices for these products--was compounded by falling prices for the country’s exports of machinery and equipment, all of which reinforced a steady deterioration in the country’s terms of trade.  (A pattern familiar to other export-driven economies like Japan and Korea who experienced a similar trend as they proceeded along the path of development.)

So, worsening terms of trade, and the persistent strength of imports tied to investment spending have had a substantial impact on China’s current account surplus.  Economists here at the IMF suggest they account for close to two-thirds of that decline since 2007.  But as I said above, there is little evidence that consumption is rising as a share of GDP.

Yes, China is increasingly becoming a source of final consumer demand for the world economy, but its imports of consumer goods are growing at a slower pace than its imports of machinery and equipment.

And in our recently released World Economic Outlook, IMF economists said they expected China’s account surplus to rise again to around 4-4½ percent by 2017, albeit with a great deal of uncertainty thrown in about the country’s structural changes.

China’s 12th Five Year Plan is very much focused on raising household income, boosting consumption, and expanding the service sector. If its proposed structural reforms to catalyze consumer spending are successful, China has the potential to successfully achieve an unambiguously consumption-driven decline in its external imbalance.  Now that really would be a rebalancing act worth celebrating.

What does this mean for China’s Asian trading partners?

Asian trading partners have benefited from China’s strong demand for commodities and capital goods. While China has become a growing source of demand for other countries in the region, its demand for investment goods has risen more sharply than its demand for consumer goods, generally by a ratio of 2 to 1.

For Asia’s leading capital goods exporters Japan and Korea, China accounts for 20-25 percent of their total capital goods exports, a fourfold increase from a decade earlier.

However, with rebalancing in China requiring a shift toward consumption-led growth, regional trading partners would also have to adapt to benefit from such a shift.

For starters, despite rapid growth, China’s role as an importer of consumer goods is still small, as it only accounts for 2 percent of global consumer goods imports.

Second, Chinese consumers have increasingly turned towards domestically produced goods as China’s share in global consumer goods imports has fallen behind its share in global consumption.

Asian trading partners have also benefitted from growing export links with China as Asia’s supply chain hub.

China today accounts for more than 50 percent of all intraregional intermediate goods imports, twice its share in the mid 1990s, and making it the center of Asia’s supply chain. As a result of greater vertical integration, Asian economies’ exports to China have increasingly been driven by the success of China’s exports in world markets.

This means however, that if the rapid growth of Chinese exports slows, Asian trading partners would also face significant headwinds. These headwinds would become stronger if China were to “on-shore” a larger chunk of the regional supply chain.

In sum, the net benefits for Asian trading partners from rebalancing in China would be larger and more lasting, if they are able to increase their direct and indirect access to Chinese consumers.