How trade surpluses hurt China

The truth about the Chinese balance of trade

The field of international development is one that attracts a lot of attention in economics, and for good reason - the act of raising global living standards in practically the raison d’être of economics, and it is certainly an issue I take a significant interest in. Inevitably however, debates within the field are dominated by questions as to what exactly is the best method of development for low-income economies.

These debates have been raging for over a century, however in modern times you will typically find discussions dominated by references to what are known as the ‘Asian Tigers’. This is a set of 4-6 (depending on whether you include early bird Japan and latecomer Malaysia) economies located in East Asia who have, within the last 50 years or so, have gone from being poorer than many sub-Saharan African economies to achieving breakneck growth, to the point where they all equal or exceed advanced Western countries in terms of living standards. When it comes to development economics, modern day theory is thus dominated by the idea that other countries should identify what these countries have done and replicate it somehow.

There are plenty of articles floating around that explain what exactly this involves, but for those interested I can highly recommend this excellent article by Yaw, which is the inspiration for this piece. Before I get into it however, I would briefly like to make a strong recommendation of Yaw’s fantastic Substack - his overviews on the histories of African countries are the best out there (far better than browsing Wikipedia!) and he also produces a number of pieces on broader economic principles and history that are exceptionally clear and concise, such as the one linked above.

Going back to the article in question however, the focus is the article is in how China has successfully managed to develop itself, and how its approach has compared to its fellow East Asian economies. The piece does a good job of explaining this, and there is no doubt that China’s initial success in this area has been a good thing - the lifting of billions of people out of poverty under Deng Xiaoping and his successors remains one of the great achievements of economic development, and I join everyone else in hoping for continuing improving prosperity for the Chinese people for a long time to come.

However, one thing the article doesn’t touch on is the implications of Chinese development upon the rest of the world. Whilst on one hand the enormous expansion of the Chinese economy has been on the most part good for the average Chinese citizen (and having a large economy that wasn’t in total meltdown was a huge benefit to the world during the 2008 financial crisis), things have been a rather more mixed issue when it comes to citizens of Africa and the rest of the world. Outside of talk of human rights and geopolitical positioning however (and overcapacity and anti-dumping measures for the trade nerds among us), there has been little mention of the ways in which this occurs, and I would argue that this is a result of three mistakes people make when analysing Chinese trade dynamics. It is the first of these that I will be addressing for the rest of this essay, with the rest following in posts to come.

The true nature of trade surpluses

If anyone has been following the output of Trump when it comes to US foreign policy, you’ll have probably heard a lot about the US’s trade deficit and the overall balance between it and China. In simple terms, a country’s balance of trade equals its exports minus its imports - if a country has a trade surplus, it means it is exporting more than it imports, and if it has a trade deficit, it means it imports more than its exports. Generally speaking, most people tend to assume that countries with a trade surplus are better at producing things than their peers, and that deficit countries have some innate problem that means they are currently less efficient at producing things than surplus countries. This however leads us to our first mistake.

Mistake 1: Assuming trade imbalances are due to weak deficit economies

Typically speaking, most discourse around trade balance occurs in trade deficit economies (the United States being the biggest) and fixates on the notion that there is somehow something wrong with said economy that needs to be fixed. If the US has a trade deficit with Germany, then clearly Germany is doing something better than them and they need to learn from them and replicate what they are doing. Thus, any situation of trade imbalance is the deficit country’s fault, and so their responsibility to fix. This line of thinking is common in discourse in the US and UK, however it is flawed, and to figure out why, one needs to go deeper into the mechanics of trade imbalances.

As stated before, a trade imbalance occurs when one country exports more than it imports (or vice versa). But what does that actually mean? Take two countries - say Germany and the UK. To begin with, they each produce £200bn worth of goods, and so their workers can be expected to be paid £200bn. In terms of where they sell their goods, they have a choice - they can either keep them at home, and use their earnings to purchase them back, or they can sell them overseas, and let their counterparts buy them instead. Let’s say the UK opts to consume £100bn of their own goods, and uses its remaining £100bn to buy German goods, thus consuming the £200bn value of their production. Germany has now exported £100bn, and the UK has imported £100bn. As it stands, Germany now has £100bn of its goods already sold overseas, and so has £100bn of goods left in Germany, and also £100bn of goods available to be bought from the UK (the other £100bn having already been bought by British citizens), and currently has a budget of £200bn. Germany thus opts to buy the remaining £100bn of its own goods, and imports £100bn of British goods. Thus, we have a position where both countries have imports and exports of £100bn, leaving them with a completely balanced trade position. In theory, in conditions where both countries’ citizens consume the value of their products, this should be the ‘natural’ outcome.

However, now we can imagine a different scenario to before. In this scenario, while both the UK and Germany still produce £200bn of goods, this time, German citizens are only paid £150bn for their work. As before, the UK opts to buy £100bn of its own goods, and then buys £100bn of German goods, leaving Germany exporting £100bn and the UK importing the same number. Germany however, is now in a slightly different position. As before, there are £100bn worth of goods in Germany and the UK each, however this time Germany only has a budget of £150bn. With domestic goods generally being more appealing than foreign, Germany once again buys £100bn worth of German goods, however this time it is only able to import £50bn of the possible £100bn of UK goods. This leaves us with a situation in which Germany is exporting £100bn but only importing £50bn, whilst the UK only exports £50bn whilst importing £100bn. Thus, from a trade balance perspective, Germany has a trade surplus of £50bn and the UK a trade deficit of £50bn, despite both being just as efficient as each other. In other words, the trade imbalance has occurred due to the policy of Germany underpaying its workers, not Britain being worse at making things.

In economics terms, this trade imbalance between the two is known as a country’s current account balance. However, you will have noticed that there is a missing piece in the above equations - namely the £50bn differential between the value of German goods produced, and the amount German citizens have available to consume. In economics terminology, this gap is usually referred to under the umbrella term of ‘savings’ and in the language of trade balances, the amount of savings a country produces and receives in the form of investment is known as its capital account balance, and takes the form of inward investments minus outward investments. This also explains how the UK can afford to buy German goods despite not having its own goods bought in return - Germans will likely be investing the remaining £50bn into the UK somehow. As an accounting rule, the sum of a country’s capital account balance and current account balance must be zero, or otherwise value would simply disappear into thin air.

When one thinks of ‘savings’, they usually think of citizens themselves choosing to pocket earned money away for a rainy day instead of choosing to consume it immediately, and this is still one way in which this occurs. In reality however, these ‘savings’ can be produced from all manner of policies, be it wage suppression, high taxation or tariffs on foreign goods. Similarly, whilst one’s natural assumption is for savings to simply be kept in a bank account earning interest from bank investments before eventually being spent, there are also numerous other ways to spend it including overseas investments and significant state subsidies.

In sum however, it can be seen that this view of trade imbalances being the result of deficit country inefficiencies is mistaken. In reality, trade imbalances are the result of activities from the surplus country, specifically those relating to artificially inflating the ‘savings’ rate. The exception to these lie in small services economies like Singapore and Ireland, and in natural resource heavy economies like Norway and Qatar; the former will typically use tax breaks and other incentives to encourage disproportionately large amounts of activity to be located there (which frequently is actually taking place elsewhere and is simply being accounted for as such), whilst the latter have large amounts of an exclusive resource to be distributed. Given both will end up significantly wealthier than their peers however, the dynamics of savings still largely apply.

The China problem

This then brings us back to our example of China. In terms of raw numbers, China possesses the world’s largest trade surplus, with Germany in a distant second. Things are a little more reasonable when it comes to surpluses as a proportion of GDP, with China being closer to the middle of the pack when it comes to surplus economies. However, these numbers are misleading - significant portions of China’s imports lie in natural resources like oil and gas that do little to stimulate wider employment in host economies. Isolate these from China’s imports and China’s relative surplus grows even larger. It’s clear then that China is one of the world’s biggest offenders when it comes to this sort of savings manipulation.

The more interesting question is thus how China does it, and what it chooses to do with its savings. The first method China uses will be familiar to those who took the time to read Yaw’s excellent article, as this is exactly the playbook behind the East Asian method of development. In this regard, elements of this behaviour could be considered justified insofar as it leads to catch up development, and so in certain areas of this China could potentially be forgiven. The issue of whether this is the case will be dealt with in the next post - for now, this piece will focus on three of the other main methods of increasing savings, and the implications of these on the Chinese economy.

First of all, compared to most other countries of similar wealth, the Chinese welfare system is incredibly weak. State health care provision is limited, and there are few examples of strong benefits systems that you might expect in places like Germany of the UK. This means that for the average Chinese citizen, there is little in the way of a safety net when it comes to things going wrong, and if things do go downhill one can find oneself in a sticky situation very quickly. This gives a strong incentive for citizens to save, so as to then maintain a reserve ready for these situations that in other countries would usually be accounted for by the state.

Secondly, China has long had a policy of active devaluation of the Renminbi. The less valuable a currency is, the more expensive foreign goods become and its own goods become far cheaper for foreign countries to purchase, despite being no more efficient at production. As a policy, this therefore effectively acts as a tax on imports and a subsidy of exports - however, it must be noted that generally speaking exports will emerge out of national production (and therefore investment), whilst imports generally take the form of consumables (intermediate goods will subsequently be re-exported and so the currency effects roughly cancel out). Therefore, a policy of devaluation can roughly be considered to be a tax on consumption and a subsidy on savings (provided they are invested in the home state).

Finally, the Chinese economy remains dominated by the state, either through central or local government. This gives said state ample opportunity to control savings and consumption rates through setting wages, engaging in more effective bargaining, mandating savings, charging taxes and any other number of policies the state wishes to conduct. It should be noted that none of these savings boosting policies are actually themselves making Chinese goods more efficient, only more competitive on the global stage.

With these established, the question now falls as to how China spends these savings. This is somewhat simpler - part of the savings must be spent on overseas investment, or else foreign markets would have no money with which to buy Chinese goods. The rest is spent domestically - partly on the social security net that the Chinese state refuses to pay for directly, and also on personal investments such as those that caused the recent real estate bubble. Above all though, as will be no surprise in such a state dominated economy, the biggest use for these is in subsidies. China has by far the largest gross formation of capital as a proportion of GDP of any notable large economy, and a substantial amount of this comes from both central and local government spending, as well as mandated internal investment (due to said currency devaluation and other policies). This also has the bonus affect of helping prop up export numbers.

With the destination of savings accounted for, we now have a complete story of how China’s trade surplus forms and manifests itself, and we can now stand back and take a look at the whole picture. What we have is a country that until recently was the largest in the world by population, and so sitting on the largest amount of potential savings. It then subsequently boosts these savings through a policy of taxing imports and subsidising exports, and by forcefully cutting its own worker’s consumption levels. It then proceeds to plunge these eye-wateringly high savings en masse into an enormously state dominated economy with all the centralisation that entails. All this happens in an government that tolerates little substantial opposition, and with a citizenry that cannot afford to lose their job due to the lack of security, and so has no choice but not to be paid the full value of their labour.

These are not the conditions for a well functioning economy. These are the ingredients for dysfunction of a truly gigantic proportion.

There is no foreign country on earth that can compete with the massed savings of almost 1.5 billion people buttressed by devaluation, meaning Chinese firms are safe from foreign competition, and the enormous grip of the state helps ensure that only predetermined actors may rise to compete with the largest firms. Meanwhile, being able to essentially swim in subsidies ensures Chinese firms need never innovate or improve efficiency beyond whatever shiny new technology is needed for geopolitical competition, and the lack of competition means they never face consequences for doing so. A lack of democracy combined with a lack of pressure then means that promotion is free to become unmoored from competence and instead dominated by nepotism and state politicking (not unlike the Soviet Union). And for all that, the iron grip of the state ensures that there is nothing workers can do about it, and the savings rate means by definition they receive nothing for their efforts.

This is not the image of an admirable economy - this is a Kafkaesque nightmare whereby huge inefficient corporations sit unmoored from competition and instead lie ruled by nepotism and bloated by subsidies of billions, from which workers *still* receive no benefit. Suddenly Trump’s 60% tariffs don’t seem so unreasonable after all.

As if that wasn’t enough, there also exists additional reasons why the US and the rest of the West are justified in being upset about this, however I will save that for Part 2 of this series, which will be coming in the next week or so.