For the past twenty years, China has run large current account surpluses. 1 1 Close From December 31, 1998 to December 31, 2018 China’s current account surplus as a percent of GDP averaged 3.5%. Source: Bloomberg. This has vexed economists because it is unusual to do so in a rapidly developing country. It has also vexed some of the people reading about it because they don’t know what the current account is. It is a common misperception that the current account is a snapshot of the government budget, when in fact it is a slightly broader indicator of a country’s trade balance. It measures how much more (or less) a country is exporting than it is importing plus net dividend and interest payments with the rest of the world. 2 2 Close The current account also includes transfer payments, but no one ever talks about those.
Prior to 1998, many developing nations ran current account deficits. They actively courted foreign investment and opened their markets. Capital came in from the developed world, which led to fast growth and big bull markets, but it was not sustainable.
When a country runs a current account deficit it must finance it, either through public or private borrowing or direct investment from other countries. Economists call this financing a “capital account surplus.” It would be nice if individuals could call their mortgages a capital account surplus and their house purchases a “current account deficit” like countries can with their purchases and borrowing.
Many of these countries became dependent on continued inflows to maintain growth and support their currencies. When those inflows reversed, the currencies collapsed and it led to a regional economic depression.
Some economists argue the problem was that they were unable to generate positive returns on projects with that capital, so it was inefficiently allocated.
In the wake of the Asia crisis, China opted for a different model. It limited foreign capital flows and put domestic savings toward building export industries. It ran big current account surpluses and used those surpluses to accumulate trillions of dollars in foreign currency (known as reserves). In theory, owning this foreign currency could help it prevent sudden devaluations in the renminbi. If Chinese authorities hold trillions of U.S. dollars, they have room to spend some of the dollars on defending the yuan if need be.
The model was very successful. China grew quickly, but it led to some imbalances. In order to have current account surpluses, China had to export more than it imported. 5 5 Close “Thank you, Captain Obvious.” This meant that a good portion of its resources had to be put toward export industries while domestic consumption of foreign goods had to be suppressed. 6 6 Close China had been accused of purposely weakening its currency to achieve this goal. A weaker currency can help make exports more competitive by keeping wages lower relative to other countries. That is why the Chinese economy looks so different from most other economies that are more tilted toward consumption. 7 7 Close One of the myths is that all emerging economies look like China with lower consumption as a percentage of GDP. In fact, China is an outlier both among developed and emerging economies in terms of the composition of its economy.
This has slowly been changing. China’s current account surplus has narrowed significantly from its peak of over 10% of GDP in 2007 and is now below 1%. 8 8 Close China’s current account surplus as a percent of GDP at its peak on December 31, 2007 was 10.1%. China’s current account surplus as a percent of GDP on December 31, 2018 was 0.4%. Source: Bloomberg. China still has a large trade surplus with the U.S., but is running deficits with many countries in Europe and Asia. There is a reasonable chance that China’s current account will fall into deficit in the near future; particularly if a trade agreement with the U.S. narrows the bilateral surplus. The decline in the current account is the inevitable result of a combination of economic growth and some policy changes. Wages in China have gone up and consumers can afford more expensive foreign goods. Boosting consumption has been a well-publicized policy goal. Higher wages have also made production less competitive, and some industries previously dominated by China have moved to other countries such as Vietnam and Bangladesh.
Chinese authorities seem to be aware that they need to adjust policy further. China can’t continue to ramp up consumption, maintain high levels of reserves, and restrict foreign investment at the same time. It would be nice if the rest of the world could buy even more of its goods to offset its rising consumption and labor costs, but China can’t force consumers in other countries to do that. 9 9 Close At least I hope not. It can devalue the renminbi, which might help return the current account to surplus, but it would be politically unpopular. It would also reduce domestic consumers’ purchasing power, so it would interfere with other policy goals. Alternatively, China could maintain current policy and defend the currency, but that would mean burning through some of its reserves, which would be undesirable.
China has another option: it can start taking in more foreign capital. It has built up enough foreign reserves and has become such a large economy that it no longer has the same vulnerabilities that plagued EM countries in the 1990s. Allowing more inflows could support the currency without reducing reserves. It could allow China to finance its projects without suppressing consumption. We are already seeing some reforms aimed at increasing foreign investment and it is possible that a final trade agreement will allow American companies and investors more access to markets in China. 10 10 Close Some folks are calling it a “concession,” but it’s not much of a concession if it’s what they may want anyway.
This is a major change not just for China, but also for the rest of the world. China has been one of the larger buyers of global assets. China will continue to invest around the world as it has, but it will also be competing with other countries for financing. This change has led some analysts to make dramatic predictions. They may argue that it will force China to sell U.S. Treasuries, but there isn’t much basis for this view. As long as China is maintaining its foreign reserves, part of which are held in Treasuries, there is no reason to sell safe assets. Others argue that if China runs a current account deficit, it will weaken the renminbi, but if China becomes a popular place to invest, capital flows could drive the currency higher.
What makes China so difficult to forecast is that accurate economic predictions often lead to incorrect market calls. The problem is that change plays out more slowly than anyone expects, and markets take years to react or, in some cases, don’t react at all. Becoming a more international open economy will challenge the culture in a country that has not always been friendly to outside investors. This will take time, but even so, it looks like Chinese markets are starting to catch up to its economy. Chinese assets are taking up more space in international indices and are becoming a larger part of global portfolios. If this trend continues, prepare to see more of that in the future.
What We Are Watching
Eurozone GDP (Tuesday)
After slowing down sharply in 2018, European data has failed to rebound meaningfully in 2019. Manufacturing surveys, in particular, have disappointed market expectations repeatedly and driven the euro and core European yields toward multi-month lows. Service sector surveys have remained more stable, providing somewhat of a backstop to the growth outlook in Europe. As an export-oriented region, the eurozone is sensitive to the strength of its trading partners, some of which continue to experience noticeable deceleration in demand for imports. Lower demand from China and Turkey, for instance, have weighed on European growth in recent quarters. With expectations for European growth having been revised downward significantly this year, it will be interesting to see the extent to which the upcoming initial estimate of first quarter GDP supports market perceptions.
FOMC Meeting (Wednesday)
The Federal Open Market Committee meets this week for its third time in 2019. The last two meetings delivered surprisingly dovish policy guidance, but the potential for meaningful surprises heading into the May meeting appears more contained. Growth data in the U.S. has held up well relative to the rest of the world and employment data has remained strong (more on this below). However, inflation has fallen below the Fed’s target and broader economic risks remain. While growth in China is showing signs of stabilizing, growth in Europe has remained weak. Further, trade negotiations between the U.S. and China and Brexit negotiations continue. Given the mixed economic backdrop and lingering risks, the Fed’s statement is likely to contain few substantial changes. Chair Powell’s press conference may be more interesting, as discussion of the threshold required to cut the Fed’s policy rates has entered Fed speeches recently and a number of question marks remain around aspects of the Fed’s balance sheet composition, potential new policy tools and the inflation target framework.
U.S. Employment Report (Friday)
U.S. labor market data has looked quite positive over the last year. Unemployment has stabilized a bit below 4%, and job growth has generally been strong. A tighter labor market has given rise to two positive trends: an increase in labor force participation and a long-awaited pickup in wage growth. The share of the population aged 25-54 (the so-called “prime age” population) that is either working or looking for work has risen over the last three years, reversing its post-recession decline. Average hourly earnings growth has risen above 3% in recent months, the fastest pace since 2009. Moving forward, market participants will be watching out for signs of slower job growth, as a number of data points have indicated some degree of deceleration in the U.S. economy. Some moderation in the pace of hiring would not be too troubling, but an abrupt deterioration could revive concerns about recession risk. This might weigh on risk sentiment and could provide a boost to U.S. Treasuries.