Must-know: Why China’s trade surplus is deceiving

Market Realist

Slowing export growth rates cull China's equities (Part 1 of 6)

Export and import dynamics in China

The below graph reflects China’s export and import dynamics. Though both imports and exports took a dive during the 2008 crisis, they’ve recovered over the past three years. The monthly trade data reflect strong and ongoing growth in the overall economy. However, the trade and economic growth data merit a closer look, as the rate of growth in the overall Chinese economy has been slowing. This series will take a closer look at China’s export and import dynamics within the context of slowing GDP growth and consider the outlook for China’s equity markets as well as its regional trade competitors, Japan and Korea.

One-way trade?

China has built an impressive export-driven economy since it embraced a more free market economy post-1976. Exports as a percentage of gross domestic product (or GDP) in China were around 5% in 1976, though they rose as high as 39% of GDP in 2006—currently standing closer to 29% of GDP. In comparison, Japan’s exports as a percentage of GDP were approximately 14% in 1976, though they’ve ranged between 10% and 18% since, while currently standing at approximately 15% of GDP. So we could see that China’s economic growth and development, relative to Japan, have been approximately twice as dependent on exporting to foreign markets. With an economy that’s now approximately 33% larger than Japan’s, China’s reliance on trade for growth has become a larger issue.

The powerhouse of emerging markets

As the graph above reflects, China also imports a lot of goods and services to keep its economy running. This is also a positive economic development for countries such as Brazil, which sell China materials such as iron ore for China’s factories. It’s interesting to note, as reflected in the above graph, that China seems to manage its export and import balance very carefully while keeping its currency pegged to the US dollar. The Chinese export machine seems to generate around $25 billion US dollars in surplus every month, or around $300 billion per year. That’s about 3.8% of China’s total economy, though only 1.8% of the US economy.

Despite being pegged to the US dollar, the Chinese Central Bank has allowed its currency to appreciate against the US dollar more aggressively since 2005 as ongoing trade surpluses have put upward pressure on the Chinese yuan. By selling so many goods in US dollars, the dollars eventually have to be sold and repatriated to China, putting upward pressure on the Chinese yuan over time. The Chinese yuan is currently about 33% stronger than the US dollar than it was prior to 2005 exchange liberalization.

However, despite the appreciation of the Chinese currency, China’s ongoing trade surplus with the United States has led to protectionist claims in the United States, which has filed its complaints with the World Trade Organization, involving the goods of autos, steel, and beef. As the United States had engaged in “Japan bashing” in the 1980s as the Japanese auto and semiconductor manufacturing industries began to dominate their US competitors, so once again the United States is bringing political pressure on China. Given the soft US economy post-2008, and the ongoing decline in real wages for America’s working class, protectionist claims are finding their way to Washington.

A self-correcting phenomenon?

Though many Americans may feel that the Chinese trade surplus these days (just like the Japanese trade surplus of the 1980s) is unfair, China, just like Japan, could eventually rely less on exports to support its more modern economy. Like Japan, China is looking at importing a growing portion of its energy needs—perhaps as much as $500 billion per annum by 2017—and will become OPEC’s (the Organization of the Petroleum Exporting Countries’) biggest customer, consuming an estimated 66% of OPEC’s output, while the US becomes increasingly self-reliant. While Japan imports fuels for approximately 42% of its energy needs, it has learned that incremental energy supply via nuclear power may not be a particularly viable alternative in light of the still problematic Fukushima power plant incident. Like Japan, China, may also reach similar conclusions, and be constrained by a high degree of energy dependence on foreign oil.

Looking forward, China will always have to be a significant exporter, just like Japan, so that it has the foreign currency required to acquire oil or energy in international markets—both dollars and euros. The United States accounts for roughly 17% of China’s exports, while the European Union accounts for approximately 16% of China’s exports. So, while China, like Japan, will remain a significant trading partner with both the United States and European Union to earn money to acquire oil, the question remains: how large of a trading partner will China be in the future, and to what extent can China rely more upon its own domestic demand to consume its domestic production capacity?

China shows some signs of slowing in absolute growth, as well as its rate of growth in export and import activity. As the Chinese currency continues to appreciate as a result of the chronic trade surplus, as reflected in the above graph, China’s trade surplus could also moderate.

Outlook

For investors who think China can orchestrate a smooth deceleration in economic growth without significant disruptions to the banking system, contain inflation, enhance productivity, and grow domestic consumption, perhaps the weakness in Chinese equity prices over the past two or three years would present a more attractive price. China’s iShares FTSE China 25 Index Fund (FXI) is down roughly 15% from its November 2011 post-2008 highs. For China skeptics seeking to embrace the more recent economic trends seen in Japan and the United States, as reflected in Japan’s Wisdom Tree Japan Hedged (DXJ) and the iShares MSCI Japan (EWJ), as well as the USA S&P 500 via the State Street Global Advisors S&P 500 SPDR (SPY) and Blackrock’s S&P 500 Index (IVV), the US and Japanese markets may appear more attractive than China’s iShares FTSE China 25 Index Fund (FXI) and South Korea’s iShares MSCI South Korea Capped Index Fund (EWY). For further analysis as to why Chinese equities could continue to underperform Japanese equities, see Why Japanese ETFs outperform Chinese and Korean ETFs on “Abenomics.”

For related analysis, please see the following series and articles.

Continue to Part 2

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