Caixin
Nov 12, 2018 10:32 PM
OPINION

Caixin View: What the End of 25 Years of Current Account Surpluses Means for the Yuan

* Shrinking surplus reflects shift in China’s economic structure over past decade

* Return to deficit could add more depreciation pressure on yuan, complicating central bank’s monetary policy

(Beijing) — Lost in the deluge of news about the first-ever China International Import Expo last week was the release of preliminary data about the flow of money across the country’s borders in the first nine months of this year in terms of trade in goods and services, and items such as investment income — what’s known in economics jargon as the current account balance.

This figure has grabbed the attention of markets this year because, for the first time in 25 years, China may well report a deficit on its current account after running up a deficit of $28.8 billion in the first half. Small surpluses in the second and third quarters have made back nearly two-thirds of the gap, but there’s still a combined deficit of about $12 billion. We think that a strong export performance in the final quarter of this year will stop China from slipping into a deficit for the full year, although other analysts are forecasting a negative number.

That’s a marginal deficit, especially when you consider how massive China’s current account surplus has been historically, but it’s symbolic because it illustrates an important shift that’s been taking place in the structure of the country’s economy. It also has the potential to affect global currency markets as a deficit in theory will exert additional downward pressure on the yuan and bring more volatility to the currency.

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A decade ago, the International Monetary Fund (IMF) was among many institutions and external economists fretting about the size of China’s current account surplus — at its peak in 2007, it stood at a whopping $350 billion or 9.94% of gross domestic product (GDP), a size the IMF warned was dangerous and contributed to the imbalances that triggered the global financial crisis.

The IMF and others advised China to lower that ratio, and indeed over the past decade that’s exactly what has happened, either by accident or design. In 2017, the current account surplus was just 1.3% of GDP. That’s come about for several reasons but here are the main ones: China’s export juggernaut has slowed down as the dividend from joining the World Trade Organization in 2001 has come to an end; China has boosted imports of raw materials such as oil and iron ore to feed its domestic economy and the prices of those commodities has jumped; there is a higher demand for more-expensive consumer goods by the country’s growing middle classes; a widening services deficit has been fueled by the surge in overseas spending resulting from the massive increase in outbound tourism.

The ongoing and intensifying trade war with the U.S. is likely to accelerate this shift by putting more pressure on the Chinese government to lower tariffs and increase imports while at the same time holding back China’s exports to the U.S., its biggest trading partner, by making them more expensive. In the third quarter of 2018, frontloading, to rush in orders before higher tariffs (rising to 25% from 10%) kick in next year, probably increased exports, and we expect the same to happen in the fourth quarter, which will push up the fourth-quarter current account surplus. However, in 2019 the frontloading factor will disappear, and we expect this high export growth to dissipate.

While China still enjoys a hefty surplus in goods trade, the size of that pile has been slipping for the last two years as imports have risen at a faster pace than exports, fueled by government policies to increase infrastructure investment amid slowing economic growth that is driving higher-than-expected demand for imports of commodities. More importantly, China has run a significant deficit in trade in services for years, and this is also widening. A big driver of this is the huge number of Chinese tourists going abroad — a recent Euromonitor International report forecast that the Chinese mainland will become the biggest source of international tourists by 2030. Although the yuan’s decline against the dollar this year may be dampening the enthusiasm of the Chinese middle classes for overseas travel, over the longer term, the trend is likely to keep going.

Yuan pressure

While economists, and U.S. President Donald Trump, debate whether a current account surplus matters at all, there’s no doubt that the markets are looking at the impact that this structural shift in the current account balance could have on China’s currency.

A narrowing current account surplus, or worse, a deficit, erodes an important source of stability for the yuan. Large surpluses have meant there’s been a steady flow of capital into China for nearly a quarter of a century. This has given the People’s Bank of China (PBOC) a war chest of foreign-exchange reserves — which peaked at almost $4 trillion at the end of 2014 — to prevent volatility in the currency, which it drew on extensively in 2015 and 2016 to avoid excessive depreciation amid a surge in capital outflows.

But as the surplus dwindles, the central bank’s ammunition is being run down at a time when confidence in the yuan is already taking a hit from a slowing economy, a trade war and a narrowing interest-rate differential with the dollar as the PBOC refrains from raising rates in lockstep with the U.S. Federal Reserve. All of these factors have the potential to suck money out of China, putting more pressure on the yuan.

Of course, there are also factors working in China’s favor — a weaker yuan will make China’s exports more attractive, which will help keep the current account surplus up. Policymakers are working hard to attract more money into the country by opening up the bond and equity markets to foreign investors and making more sectors of the economy accessible to foreign companies, such as financial services. In addition, the result of the U.S. midterm elections will probably stall any further stimulative policies from the Trump administration, helping to keep the dollar from strengthening too much.

But despite the positives, the PBOC is going to have to work hard to find ways to control yuan volatility and capital outflows if it is to prevent its foreign-exchange reserves, currently standing at just above $3 trillion, from falling to a level that could spook the markets even more. The IMF reckons China needs reserves of at least $2 trillion to meet its obligations.

The end of current account surpluses is an important milestone — it marks a turning point in the country’s growth model away from export-driven growth toward one driven by consumption. But it’s not happening at a good time for the currency, and is yet another factor that’s weighing on the yuan. With strong capital controls and a massive hoard of foreign-exchange reserves, the PBOC still has ammunition to stop the currency from depreciating too fast. But the end of the surplus era has brought the loss of an important backstop, and that in itself could become a source of instability.

Calendar

November 14: NBS releases October industrial production and retail sales, January-October fixed-asset investment, real-estate investment and sales, end-September surveyed urban unemployment rate

The People’s Bank of China may release money-supply, new-loans and total social-financing data for October this week

The Ministry of Commerce may release foreign direct investment and outbound direct investment data for January-October this week

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