China's Trade Surplus Gets Dangerous

Standard Chartered economist Stephen Green sees Beijing making economic history this year with an estimated $400 billion account surplus

by Stephen Green

Think you've already seen the biggest surpluses out of China? Are you sitting down? We believe China's current account surplus will balloon to $400 billion this year, or 12.8% of gross domestic product, up from $256 billion in 2006. This is a massive number, the biggest surplus—in dollar terms—the world has ever seen. Our forecast is also significantly bigger than that of the World Bank (8.3% of GDP), the International Monetary Fund (10% of GDP), and as far as we can tell, the rest of the street, too.

The general assumption out there seems to be that the surplus will grow this year by roughly the same pace as last year. In contrast, we believe that China's overall surplus is accelerating, and that Beijing's administrative efforts to control it are having a marginal effect at best. This forecast is so large, and so sudden, that it almost seems unbelievable. We do not make it lightly. Here is our thinking.

First, the processing export boom is continuing. The largest part of China's surplus comes from processing: Import $100 worth of goods, add labor and other costs, plus a margin, and export $130 worth of goods. That $30 value-add becomes a surplus on a huge scale, since half of all China's trade is processing. Add more processing investment via foreign direct investment and domestic firms, and you get more processing, as well as a bigger processing surplus.

Increase in Value-Add

The key here is that this bit of the surplus only gets smaller if processing trade growth goes to zero and then reverses. Any growth whatsoever in processing trade delivers a bigger processing surplus. Processing trade growth is clearly decelerating, as global growth calms. However, it is still growing at a significant pace.

In the first quarter, processing imports grew 11% year-on-year, compared to exports' growth of 25% year-on-year. As a result, the processing surplus in the January through March period alone was $54 billion, a full 70% larger than in the first quarter of 2006. In addition to the simple mechanics of more investment, the key here is increasing amounts of domestic value added. Think onshore-produced chemicals going into plastics; think onshore-manufactured steel going into white goods; think onshore firms moving up the value chain and producing auto parts; and so on.

But the processing story is an old one. And while processing creates the country's natural disposition to large surplus, if China is importing vast volumes of raw materials and capital goods for its own industry, as it did before 2005, then the trade account will be in rough balance. The big change in the dynamics of the past two years has been the unexpected recovery in the 'real' trade deficit. China's hardly exists.

Getting the Goods

Why? The initial stimulus was the collapse in 'real' import growth in 2005. This was partly an inventory adjustment, particularly as raw material importers attempted to wait out high global prices, and partly the result of administrative measures which hit investment. Then import growth recovered after inventories had been emptied and controls relaxed.

But at the same time, real export growth accelerated. Why? Because thanks to all the investment in the steel, aluminum, chemicals, auto parts, etc. sectors, China was ready to become a major capital-intensive goods manufacturer. By our very rough calculations, 10 years ago some 40% of China's exports were capital-intensive. Now that figure is approaching 60%.

We have to ask if this is going to change. One school of thought says it will, meaning the surplus will stop growing soon. It argues that the massive 2003-05 investment wave unwittingly resulted in excess capacity, and as a result there was diversion of production into overseas markets.