The tectonic plates that underlie China’s economic growth are shifting rapidly, and perhaps as early as next year, the country will for the first time in over 30 years slip into a trade deficit, with huge implications for other economies and, in particular, for the US dollar.
“China, the world’s largest creditor, is about to move from monthly trade surpluses into the unfamiliar territory of substantial trade deficit,” Societe Generale economist Glenn Maguire told DNA Money in Hong Kong on Monday. “There are many profound implications of this that markets have not even begun to consider… It could be the next event risk for markets.”
The turnaround in China’s trade balance is happening extraordinarily rapidly. In 2008, for instance, it posted a cumulative trade surplus of $300 billion. But owing to a collapse in consumer demand in the developed economies following last year’s financial meltdown, and China’s efforts to boost domestic demand, that surplus will shrink to around $100 billion in 2009, and reverse into a full-year deficit of $100 billion in 2010, reckons Maguire.
“China is moving to boost domestic demand while external demand remains quite weak. The logical conclusion of this, if China succeeds in achieving this policy goal —- and we think it will —- is that the trade balance will slip into deficit.”
The reason why this is significant, explains Maguire, is that China, which has been a significant holder of US Treasury debt, “will no longer be the marginal buyer of US Treasuries if its foreign exchange reserve accumulation slows” —- or reverses, as could happen if China slips into trade deficit.
“Markets have assumed that China will absorb any issuance of US Treasury, but when China moves into a trade deficit, we could potentially see some drawdown in its foreign exchange reserves,” says Maguire. “This raises the question of who ultimately is going to pay for the strong fiscal policy response in the US.” The ability of the US to finance its ongoing trade and fiscal deficit will become more difficult as surplus economies move into deficit, with negative implications for the dollar, he reckons.
“As the US continues to run twin deficits, and its ability to finance those is increasingly questioned, it will be a ‘US dollar weakening’ story.” Inversely, he adds, as China moves into its first sustained deficit for 30 years, it will be very difficult to make the argument that the yuan is undervalued.
China’s trade surplus will, however, not vaporise; instead, it will get transferred to Japan, Taiwan and South Korea, which export capital goods that are leveraged off China’s infrastructure projects. Australia and Russia, which export commodities to China, will also be beneficiaries of China’s import-intensive “economic salvation” policy, Maguire believes.
“To an extent, we will see a recycling of what was China’s trade surplus into higher trade surpluses in Japan, South Korea and Taiwan, who are also very high holders of treasuries,” says Maguire. But the risk is that “even their recycling of surpluses into dollar assets may not be sufficient to offset the shortfall” from China’s absence at the table.
Therefore, US domestic investors - households and financial institutions - will eventually have to become major buyers of US Treasuries. Higher savings rates in the US support that, but, US domestic investors “will likely require higher term premiums than China has demanded in the past,” argues Maguire. “It would probably require higher yields so bond investments look attractive.”
The sustainability of fiscal policy is clearly at its limits, says Maguire. “It will be one of the challenges of managing the exit scenarios from a very loose monetary and fiscal policy in 2010-2011.”
