A Multi-Country Evaluation of Trade Imbalances
Table of Contents
Developing countries as well as many industrialized countries at the earlier stages of development, have used net capital inflows, in the form of foreign trade deficits, to maintain a higher long-run rate of investment than could be achieved by relying on domestic savings alone. This strategy is beneficial only if the investment is efficiently allocated, meaning that the productivity of the investment exceeds the cost of foreign capital. During the period from 1982 to 1997, China has experienced two periods of trade deficits, and three of surplus. It has maintained its net debtor position, while backing up its debt with sovereign guarantees. In the late 1970s, China began reforming the economic system and the evaluation of the current accounts takes place within this context. The administration's intent was to incur sustainable foreign trade deficits while cautiously relying on external finance.(1) The success of sustaining the deficit depended on the ongoing process of reform aimed at improving the efficiency of investment and accessing of foreign technology and capital.
In this chapter, we will evaluate China's trade imbalances between 1982 and 1997. Deficits were recorded from 1984 to 1989 and 1993-4. Surpluses were recorded during 1982-3, 1990-2, and 1995-1997. Generally, deficits occurred when the authorities enacted more aggressive reforms, resulting in the expansion of demand and credit. Authorities then eliminated the deficits by retracting reforms, tightening credit, and limiting imports. Throughout this fifteen year period, gross domestic product (GDP) rose by 900 percent from less than 1 billion Yuan during the 1970s to reaching 8 billion Yuan during the late 1990s (Fig. 14.1). The real GDP growth rate was at an average of eight percent annually, only recorded under five percent growth for three years. In addition, real GDP per capita has risen consistently since 1982 (Fig. 14.3). These results are impressive for a country of China's size, but these indicators do not tell the complete story. The growth in GDP and GDP per capita is not necessarily reflective of an increase in living standards of households. In fact, fewer restrictions on imports would potentially further increase living standards. Economic development has occurred unevenly, and has been mainly limited to coastal areas that have been designated as Special Economic Zones (SEZs).(2) Although these indicators mask the impact of economic growth on living standards, it is clear that reforms enacted since the 1970s have had tremendous impacts on the economic system. In particular, trade imbalances have occurred in tandem with reforms and have been extinguished via administrative controls. The discussion that follows will illustrate that the reform process may have perpetuated macroeconomic cycles and led to trade imbalances that were subject to control via erratic policy instruments. Although the indicators shown above provide a positive picture of China's economic growth during the last fifteen years, the discussion of each particular period of deficit and surplus will emphasize the unevenness of growth and the administration's use of command-and-control policies.
In the period after the 1949 revolution, China pursued a strategy of socialist economic development based on principles of self-reliance and a centralized allocation of resources.(3) During the late 1970s, Chinese policymakers turned their focus to economic efficiency and technological progress and initiated a process of reforming the economic system and increasing trade and investment. Reform was intended to facilitate the import of technology to modernize the economy and increase growth rates via a transition to market mechanisms.(4) The legacies of central planning were a distorted pricing system, inefficient resource allocation, concentration of investment in heavy industry at the expense of basic infrastructure, stagnation in agricultural production with shortages of nongrain products, isolation from foreign competition, a pervasive emphasis on quantity rather than on quality, and slow growth in per capita consumption with acute shortages of many consumer goods and housing.(5) During the past two decades, the administration has begun to reform State-Owned Enterprises (SOEs), formed Special Economic Zones (SEZs), and initiated trade system liberalization and price reforms.(6) The process of sustaining economic growth has been uneven because it was initially largely confined to specific enclaves in coastal areas and other special economic zones. However, it has begun to expand to engage several inland and border areas.
Net Investment Position
China's exact net debtor position is not known. Analysts suggest that this is partly due to the uncertain equity position. Companies exhibit tendencies to underinvoice and receive payments in foreign currency in offshore accounts. These holdings are not disclosed and escape the government's scrutiny. This reflects the strictness of the government's foreign exchange controls. The government aims to maintain high levels of foreign exchange reserves in order to have a cushion in meeting debt payments. Foreign exchange reserves rose from $10,091 million to $80,288 million from 1980 to 1995.(7) Total debt as a percent of GNP has been declining since 1993. China has not had to reschedule any debt between 1970 to 1995. Service payments have been met without default. Maturity for new commitments with all creditors (official and private) between 1980 and 1995 ranged from 11 to 18.4 years. Opinion among officers at multilateral investment agencies reflects that China's reputation with creditors has not been compromised in the last two decades.
The government has accrued debt from financing public infrastructure projects, which during times of economic slowdown, have been used as a growth engine to keep the economy from contracting (Fig. 14.4). In 1995, almost sixty percent of the long-term obligations were denominated in U.S. dollars, while an additional twenty percent in Japanese Yen, and around seventeen percent in multiple currencies. External debt is comprised mainly of long-term obligations, which are publicly guaranteed. Unlike other emerging markets, China has restricted private capital inflows, wishing to remain independent of foreign investor perceptions and capital flight. The figure below illustrates that short-term debt has never reached five percent of GNP from 1988 to 1995 (Fig 14.5). On average, it has also only represented seventeen percent of total debt from 1980 to 1995. The administration has kept tight control on short-term, non-guaranteed, private debt. Portfolio equity flows were first recorded in 1991 and represented fifteen percent of net foreign direct investment, which itself was greatly limited to the Special Economic Zones. Foreign direct investment was first allowed in 1988, but increased seven-fold by 1995 and clearly dominates net resource flows.
Given that China has sustained phenomenal growth rates, as well as its net debtor position without reaching default, some economists characterize the administration's policies as fiscally responsible. However, others argue that the maintenance of surpluses has suppressed GDP growth and domestic investment. The situation in 1993 may illustrate this point: a current account deficit of almost two percent of GDP, total debt stocks at almost 20 percent of GNP, and declining GDP growth (although still at 12 percent). At this point, domestic investment took a sharp turn downward, GDP growth continued declining, government and personal consumption remained at the lowest levels in ten years, while the debt and the deficit took a turn for the better, decreasing dramatically. It can be argued that domestic investment and GDP growth were compromised in order to return to a current account surplus and relieve the debt burden that has been gradually increasing. Throughout the period from 1982 to 1998, China had maintained high growth rates, however, and utilized external finance at the administration's discretion.
Although the risk of default does not appear imminent, recent events are bringing to light the impact of the Asian crisis and it remains to be seen whether the administration can keep up the balancing act. The sudden closure of the Guangdong (GITIC) in late 1998, due to its indebtedness are suggesting that the government will not guarantee all foreign investments. It is becoming apparent that China's ability to service its debts may be compromised in 1999, as central government revenues represented only 12 percent of GDP last year, which is low compared to the developing country average of 32 percent(8). In addition, sixty percent of these revenues were raised by issuing debt, based on China's creditworthiness. Of this debt, 70.9 percent went towards servicing other debts. Historically, it appears that the administration will take the necessary measures not to compromise its ability to service debts and to maintain its creditworthiness. The impact and nature of such measures is as yet uncertain.
Although many economists have analyzed the reform process by breaking it down into cycles, we will consider five periods of trade deficits and surpluses and macroeconomic cycles.(9) In 1982-3 China experienced a trade surplus. From 1979 to 1982, agricultural reform was initiated as the government chose to increase subsidies, rather than allowing the higher agricultural procurement prices to be passed on to consumers. While government revenues decreased, rural incomes rose due to the subsidy relief. During this period, profit transfers to the state were partially eliminated as enterprises were allowed to retain profits. These increases in income led to a surge in aggregate demand and domestic investment rose sharply. Although credit was expanded to accommodate demand growth, inflation accelerated to nearly 20% on an annualized basis, and the trade balance began to quickly deteriorate. The authorities responded by tightening price controls in 1980, direct credit controls and trade policies during 1981, and slashing the state's investment budgets. Inflation fell, output growth moderated, and with a short lag, import growth was compressed and the trade balance swung into surplus by the third quarter of the beginning of 1982 (Fig. 14.6).
China experienced a current account deficit for the following five years. In 1984, the administration introduced the two-tier pricing system. Enterprises were granted greater autonomy in setting wages, while already operating under traditionally soft budget constraints. The large increases in wages and investment spending resulted in a sharp rise in aggregate demand. While a two-tier banking system was established, the People's Bank of China had not been vested with the instruments necessary to control credit expansion. By mid-1985, inflation and import growth had risen sharply. The further liberalization of the foreign trade regime during this period led to a spillover of excess demand into the balance of payments. This is the largest current account deficit between 1982-1997 reaching four percent of GDP (See Fig. 14.6). As GDP growth rates had been gradually decreasing from 20 percent to eight percent between 1983 to 1986, government and personal consumption also showed a decline from 1982 until 1987 (Fig. 14.7). Higher rates of investment inflows were not offset by imports and consumption. Once again the authorities responded by tightening credit, foreign trade, and exchange controls. In addition, interest rates were increased and the renmibi devalued, resulting in a decrease in the size of the deficit.
Beginning in 1987, the deficit grew until it reached one percent of GDP and then decreased (See Fig.14.6). From mid-1986 to late 1988, the contract responsibility system for enterprises was introduced, restrictions on the operations of specialized banks were lowered, and universal banks were established. Aggregate demand growth accelerated due to a sharp deterioration in the overall budgetary balance. The increases in several administered prices in early 1988 were implemented in an already overheated economy and exacerbated existing inflationary expectations. A system-wide entrenchment began in late 1988- under which administrative controls on imports and credit were tightened, some price controls were recentralized, and state investment expenditure was slashed. The authorities aimed to return to a surplus, and took measures that resulted in the lowest GDP growth rates since 1982, and the lowest levels of domestic investment between 1982 to 1997 (See Fig. 14.6, 14.8). Interest rates were increased, and the renminbi was devalued by 21 percent in 1989. These command-and-control policy directives closed the deficit and led to a three year period of trade surpluses, 1989 to 1992. As illustrated previously with similar events in 1993, the administration compromised economic growth, demand and import-consumption, in order to maintain a surplus and not compromise its ability to service debt payments.
Following a hiatus of almost three years, the pace of reform began to regain momentum in 1991. As is observed in Figure 14.6, at this point, the size of the surplus began to deteriorate as reform picked up momentum. In addition to rationalizing the price system, some steps were taken to increase the exposure of SOEs to the markets and to make them responsible for their profits and losses.(10) Prices of commodities that were previously considered "off-limits," such as the urban ration prices of grain and various energy products, were adjusted. Grain prices were completely liberalized in several provinces. The acceleration of reforms once again fueled an investment boom that by and large was accommodated by expansionary domestic financial policies. The growth of domestic investment reached 30 percent in 1992 and 37 percent by 1993. (Fig. 14.8).
Signs that the economy was being stretched to its limits began to emerge during 1992 in the form of shortages in critical areas such as transportation, energy, and industrial raw materials. Inflation accelerated, especially during the first half of 1993, when the 12-month rate of change in the national retail price index was over 10 percent, and the urban cost of living index surged to almost 20 percent. At the same time, import growth topped 25 percent, and export growth progressively slowed to below 10 percent as goods were diverted toward domestic markets. Consequently, China's most recent deficit emerged in the trade account (See Fig. 14.6). This deficit is measured at two percent of GDP. The authorities implemented small increases in interest rates on deposits and loans in May and again in July 1993 in order to respond to the concern about heightened demand pressures. The number of permitted development zones was limited and the central bank was strengthened to ensure that the credit plan would limit credit expansion through non-bank financial intermediaries.(11) In addition, government expenditures were reduced by 20 percent and price reforms were postponed as part of an austerity plan. In 1994, the currency was devalued, leading the trade balance to shift back to a surplus.
Since that time, China's trade balance has been in surplus, allowing it to continue with the pace of reforms. China's economy has been affected by the emergence of the Asian Crisis, and may be on the verge of another devaluation.(12) As demonstrated in previous cycles, when the surplus shows signs of decline, the administration pulls back reforms and steps in. The administration has commented that its commitment not to devalue is not permanent, and will be re-evaluated based on the competitiveness of China's exports if other neighbors devalue.(13) The government has increased spending on infrastructure throughout 1998, and emphasizes stability over survivability by setting billions aside for bad loans, instead of shutting down bad firms. The shutdown of Guangdong International Trust and Investment Corporation (GITIC) shocked foreign bankers who believed their loans were guaranteed.(14) As exports decline further, the authorities will again, as evidenced by past behavior, implement strict administrative controls such as restricting imports, in order to maintain the surplus.(15) The coastal export zones have been declining due to the loss of demand from China's neighbors and main trading partners. It has been observed that authorities have already pulled back from closing non-performing SOEs. With regards to capital outflow, at least $45 billion has been reported missing due to companies with hard currency debt higher than anticipated, smuggling money out of the country as a result of their anticipations of a more pronounced slowdown. Deflation, unused inventories, and the decline in foreign investment are all indicators of this slowdown.(16) As foreign investors are scared off, China loses access to new technology, capital, and management which is crucial for increasing the efficiency of investment and spurring further economic growth.
The convergence of China's trade pattern toward market-determined comparative advantage is a significant result of economic reforms. China changed its status as the twenty-sixth largest exporter in the world in 1980 to the thirteenth in 1991.(17) China's gains from this convergence are an increase in the share of foreign trade in GDP, and an easing of the pressure of excess domestic demand. However, it became evident that in some cases, the administration could have allowed a higher level of imports to meet increasing demand and cushion against inflationary pressures. The growth rate of manufactured exports has greatly exceeded the growth rate of total exports. Trade system reforms have had tremendous impacts on increasing the investment rate and the GDP growth rate. However, officials privately agree that growth rates significantly overstate reality.(18) The export supply potential of China may be determined in great part by acquiring membership to the World Trade Organization (WTO) which will help ease the concerns of Western governments regarding regulation and enforcement. Under current debate is whether the liberalization of the trade system will continue in the face of economic slowdown.
During the late 1970s, the Chinese faced out-dated technology, policies focused on heavy industry, and inefficient corporate management.(19) Since 1978, China's economy has exhibited growth rates on average of eight percent per year (See Fig.14.2). Although there is a consensus that these numbers are somewhat overstated by the Chinese government, economists believe that they are not very divergent from reality. In great part, this is attributed to the tremendous gains in efficiency, in addition to the shift of labor from low productivity agriculture to high-productivity industry, combined with rapid urbanization, and absorption of foreign technology(20) In fact, some economists have theorized that a sharp increase in the growth of total factor productivity accounted for over 40 percent of total growth in real net material product between 1977 and 1985, and growth in the labor force and in the capital stock accounted for the remainder.(21)
China's trade imbalances reflect that during the last 25 years the administration has perpetuated macroeconomic cycles in its efforts to spur growth and maintain a sustainable net debtor position. Since the late 1970s, the cycle starts with an increase in aggregate demand caused by reforms and ratified by credit expansion. This gives rise to the emergence of shortages and bottlenecks in critical sectors, intensifying pressures on prices and on the balance of payments. The administration attempts to stabilize the economy via administrative controls, which lead to a slowdown. This retrenchment prompts renewed calls for credit relaxation, thus setting in for a further round of macroeconomic instability. These policies reflect the government's sanction of SOEs and the limited autonomy of the banking system to turn down the loan requests.(22)
Clearly, the absence of effective institutions and instruments for macroeconomic management aids in the persistence of these cycles. Administrative control measures impose abrupt and at times excessive restraints on the economy, leading to countervailing pressures for subsequent relaxation. Policy is transmitted to real economic activity through very erratic mechanisms. While attempting to transition from a centrally planned economy, the administration faces the challenge of implementing reforms that eliminate these mechanisms. Trade imbalances are still subject to the direct controls imposed by the administration. In addition, regional issues of the unevenness of economic development have yet to be addressed. China's trade surplus and net debtor position is worrisome because at times, the administration has chosen to trade productivity growth for command-and-control policies that compromise growth, domestic investment and demand. The question remains as to whether the administration will derail from the path of reform in light of recent events in order to once again avoid a current deficit.
Aghevli, Bijan. "Controlling Inflation: A Principal Policy Challenge for China." in Mundell, et al.
Barnathan, Joyce, and Jonathan Moore, and Sheri Prasso, and Dexter Roberts,
"China: Plans for Reform Are Screeching to a Halt as it enters a year of economic peril," Business Week, 22 February 1999.
Bell, Michael W., Hoe Ee Khor, Kalpana Kochhar, China at the Threshold of a Market Economy, International Monetary Fund, Washington DC, September, 1993.
Broadman, Harry G., Policy Options for Reform of Chinese State-Owned Enterprises, World Bank, June, 1996.
Byrd, William, The Market Mechanism and Economic Reforms in China. M.E. Sharpe, Inc: New York, 1991.
Jacob, Rahul "China: Citic Pacific Chief Urges Caution." Financial Times, March 30, 1999.
Kynge, James. "China: Big Push Planned to Reverse Export Fall," Financial Times, December 11, 1998.
Mundell, Robert and Manuel Guitian, ed. Inflation and Growth in China, International Monetary Fund, Washington: 1996.
Perkins, Dwight H. "Reforming China's Economic System," Journal of Economic Literature, Vol. 26, June 1988.
World Bank Country Economic Report, China: Long-Term Development Issues and Options. Johns Hopkins University Press: Baltimore, 1985.
World Bank Global Development Finance, 1997.
Brief Overview of China's Special Economic Zones (SEZs)
Special Economic Zones (SEZs) have pioneered the changing economic structure in China. As mentioned earlier, until the early 1990s, economic development was limited to these zones, which served as testing grounds for the whole domestic economic system.(23) Regional differences in terms of level of development and endowment structure are major issues for China's reformers. The purpose of the zones was to facilitate technology transfer, provide employment opportunities, and earn foreign currency. SEZs have been defined as:
districts, confined to areas that meet certain requirements, that promote the country's overall economic development, that operate in a free management system different from the rest of the country; that allow many types of corporations to conduct business activity, including wholly-foreign capital investment; and that contain a wide range of businesses, including industry, agriculture, livestock, fishery, commerce, real estate, tours, finance, and insurance. In this regard, the SEZs go beyond their former status as free ports or export processing areas and can truly be called overall economic development areas.(24)
The economic performance of SEZs has been impressive, although economic growth was not solely achieved by the injection of foreign capital. The value of exports from SEZs doubled from 1987 to 1991, reaching $6.6 billion or about 9 percent of China's total. Contracted foreign investment in 1991 was more than eight times its 1987 level and total real gross industrial output showed strong gains, increasing by over 35 percent in 1991.(25) The zones are exhibiting problems, related to poor management, laborers used as expendable commodities, and illegal trade. Although the effects of the SEZs are yet to be promulgated throughout China, the goal is to achieve external economic expansion of the entire Southern Chinese economic block. The success of this block has sparked similar movements along the coastal areas with the intent to form regional economic networks.(26) These movements are considered tremendous progress in the sense of revitalizing regional economies, mainly because they represent a transformation from the old system. Whereas the provincial administrative districts served simultaneously as economic units, now economic divisions are also determined by market mechanisms.
Brief Overview of State-Owned Enterprise Reform
Reform of state-owned enterprises (SOEs) has been a major goal of the authorities since the late 1970s. Although SOEs account for only one percent of all Chinese enterprises, they produced 43 percent of the country's industrial output.(27) However, despite their sizable contribution to the economy, SOEs have also exhibited numerous inefficiencies which the government has been attempting to reform. Due to the inefficiency of SOEs and the lack of imposed budget constraints, government revenues have been continually used to provide subsidies and maintain employment in inefficient SOEs.(28) This resulted in pressures on balance of payments and prices, due to bottlenecks in critical industries.(29) Authorities are currently aiming to find market-driven ways to eradicate poor management, which is something that happens automatically in economies with well-developed capital markets. The starting point may be corporatization, adoption of internationally accepted accounting principles, and regular, required, publication of SOE balance sheets. Financial-debt restructuring, perhaps debt-equity conversion, creating joint-stock companies, public sale of shares are options for meeting the administration's goal to get SOEs to function by market-determined factors, and in the face of competition.
1. World Bank Country Economic Report, "China: Long-Term Development Issues and Options." Johns Hopkins University Press: Baltimore, 1985, p.107.
2. See Appendix for a brief discussion of Special Economic Zones.
3. Bell, Michael W., Hoe Ee Khor, Kalpana Kochhar, "China at the Threshold of a Market Economy," International Monetary Fund, Washington DC, September, 1993, p.1.
4. Byrd, William, "The Market Mechanism and Economic Reforms in China." M.E. Sharpe, Inc: New York, 1991.
5. Bell, p. 6.
6. See Appendix for a brief discussion of reform of State-Owned Enterprises.
7. World Bank Global Development Finance, 1997.
8. Kynge, James. "China: Yardsticks Reveal Fiscal Woes," Financial Times, April 7, 1999.
9. Bell, p.66.
10. Broadman, Harry G., "Policy Options for Reform of Chinese State-Owned Enterprises," World Bank, June, 1996.
11. Bell, p.61.
12. Barnathan, Joyce, and Jonathan Moore, and Sheri Prasso, and Dexter Roberts,
"China: Plans for Reform Are Screeching to a Halt as it enters a year of economic peril," Business Week, 22 February 1999, p. 48-50.
13. Harding, James. "China: Softening on Currency Pledge." Financial Times. April 8, 1999.
14. Jacob, Rahul "China: Citic Pacific Chief Urges Caution." Financial Times, March 30, 1999.
15. Kynge, James. "China: Big Push Planned to Reverse Export Fall," Financial Times, December 11, 1998.
16. Barnthan, et at, p. 49.
17. Bell, p.60.
19. Park, p. 195.
20. Mundell, Robert and Manuel Guitian, ed. "Inflation and Growth in China," International Monetary Fund, Washington: 1996, p. 2.
21. Perkins, Dwight H. "Reforming China's Economic System," Journal of Economic Literature, Vol. 26, June 1988, p. 601-645.
22. Aghevli, Bijan. "Controlling Inflation: A Principal Policy Challenge for China." p. 293.
23. Park, Jung-Dong, "The Special Economic Zones of China and Their Impact on Its Economic Development, " Praeger: London, 1997. P. 198.
24. Park, p. 196.
25. Bell, p.41.
26. Park, p. 198.
27. Broadman, p. 226.
28. Harrold, Peter, E.C. Hwa, and Lou Jiwei, ed. "Macroeconomic Management in China." World Bank, 1993. p. 38.
29. Mundell, p. 293.
©1999 The Elliott School of International Affairs, The George Washington University, ALL RIGHTS RESERVED Last Updated on 10/9/99