China’s Balance of Payments Matters More Than Ever

China’s reliance on external demand for growth is unsustainable in the long term. Yet the Chinese government seems to be pursuing a policy reliant on export-led growth. What are the implications of this deliberate policy choice being made by China?

This piece is the last of a three-part series on China that explores the country’s property sector, growth conundrum, and external challenges.

In our first commentary in the series, on China’s property sector, we highlighted that the troubled property sector poses limited financial spill-over risks but has eviscerated a core source of growth for the country. In our second commentary, we argued that the property-led drop in capital investment will require China to pursue broad structural reforms to ensure that its current economic expansion is maintained. In this final piece, we explore the implications of China continuing to rely on external demand for its growth, which is how the country has so far navigated economic downturns.

It is clear that in the absence of broad structural reforms, the Chinese economy will surely need to rely on external demand to sustain its current growth rates. However, this model is increasingly running out of steam as the country has simply become too big to rely on export-led growth without triggering a pushback from major trade partners.

Reliance on Trade Fraught with Economic and Political Risks

Trade with China has become a sensitive political issue, particularly now that the country’s export mix is increasingly driven by higher value-added goods. Although export-led growth is a tempting fall-back option for Chinese policy makers, continuing to rely on it is fraught with political and economic risks. In simple terms, China’s major trade partners are not ready for even more Chinese exports.

Not only will more exports exacerbate the political tensions between China and developed economies, but any counter measures its partners take will also dampen the growth effect that China hopes to achieve. To understand the magnitude of China’s weight relative to its historical past, it would be worthwhile to illustrate the economy’s goods exports as a percentage of total world exports from 1980, which is roughly when China began integrating with the world economy (Figure 1).

By the time China entered the World Trade Organization (WTO) in 2001, the country was already an established exporter, although its share of global trade was still relatively low. It was in the years that followed that China became an export powerhouse, and Chinese trade became a controversial point in Western industrial politics. On the back of pandemic-induced domestic weakness (fewer imports) and stimulus-supported foreign demand, China’s net goods surplus has only risen further, reaching an all-time high as a share of global trade in 2022. This is not sustainable, and any continued rise will coincide with further geopolitical turbulences.

China’s Growing Clout in Trade a Deliberate Choice

To be clear, China’s growing clout in trade is not a side effect of flagging domestic demand, but rather a deliberate policy choice made by the Chinese government. The government has in recent years invested in industrial capacity that stimulates exports but has not balanced that with efforts to bolster domestic demand for imports. This applies not only to goods but also services, with Chinese outbound tourism only reaching half that of pre-pandemic levels. More recent monetary easing in response to weakness in the property sector has added to the trend, as it has reduced the cost of funding for exporters.

The targeted support for industries reflects China’s desire to take a leading role in technologies that are expected to drive the transition to a lower carbon world. In particular, China now dominates the supply chains of solar cells as well as electric vehicle batteries. But this dominance is not cost free. Given the centrality of low carbon technology in economic planning, this is triggering China’s trade partners to activate a countervailing industrial policy not only to protect domestic industry and workers, but also for national security reasons. Indeed, the threat in areas such as electric vehicles poses an existential challenge to economies in Central Europe built around the automotive industry. Trade tensions are likely to worsen as a result.

In September, the European Commission announced a probe into Chinese subsidies for electric vehicles. This is a harbinger of future measures, either in the form of explicit tariffs or other penalties aimed at protecting domestic producers. As we witnessed with US tariffs in 2018, cost pressures on exporters can be offset by currency depreciation, which means trade wars could easily precipitate a currency war. Given the global geopolitical environment, severe economic imbalances in one of the largest economies of the world could have greater consequences than just frayed trade relations.

What Does This Mean for Investors?

Should China continue to rely on external demand, it will perpetuate support to the export sector by further creating excess capacity. This is inherently deflationary, both in the broader sense that this growth model is running out of steam and in the specific sense that excess production may end up on global markets at a discount. This should support lower bond yields in China and help disinflation trends in developed markets.

In turn, this should also weaken the real effective exchange rate, especially as a lack of domestic investment opportunities keeps capital outflow pressure high. As far as the Chinese yuan is concerned, any increase in trade tensions is likely to push it lower over the medium term as a mitigator of potential tariff measures.