EU-China Economic Observatory

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1 The European Union s FWC COM 2011 Studies and Technical Assistance in All Sectors EU-China Economic Observatory Issue n 17, June 2013 Final Report Contract N 2011/ A project funded by The European Union Implemented by AETS and written by TAC

2 Contract N 2011/ FWC COM Lot 1 Studies and Technical Assistance in all Sectors This China Observatory aims at providing information and analyses on recent development in the Chinese economy, with a focus on trade and investment issues. It is based on a systematic use of available statistics and the ChinaObs fdimonitor (COFM) website on China, as well as the collection and review of news, academic articles and other sources of qualitative information. It also relies on contacts with other experts on China. As a general rule, we do not restate the elements of a global view that has been expressed in previous issues of the Observatory, unless we consider that these views are affected by new events or analyses. The contents of this publication are the sole responsibility of TAC and can in no way be taken to reflect the views of the European Union. The writing of this issue was completed on July 3, TEAM COMPOSITION Thierry APOTEKER, Team Leader Chief Executive Officer, TAC thierry.apoteker@tac-financial.com Sylvain BARTHELEMY Executive Director and Head of Research, TAC sylvain.barthelemy@tac-financial.com Isabelle LEGRAND Senior Economist, TAC isabelle.legrand@tac-financial.com Sandrine LUNVEN Quantitative Economist, TAC sandrine.lunven@tac-financial.com

3 Table of Contents 1 KEY MESSAGES 1 2 CHINA S CYCLICAL PERFORMANCE A country-risk approach to the current economic situation in China Key findings Growth Balance Debt Balance Liquidity Balance Foreign Exchange Balance Cyclical Balance Banking System Balance Consensus outlook for China Summary of China s cyclical indicators 20 3 CHINA S TRADE MONITOR Overview of China s trade performances and challenges China s trade performances and dynamics Development in China s trade policy and diplomacy Exploring discrepancies in trade data Analysis of China s trade partners and products Diversification of trade flows US and EU compared Evolution by products EU-China trade developments Overview Trade Performances of EU Member States 40 4 FOREIGN INVESTMENT Full light on the cloud of FDI statistics FDI statistics: a question of concept Key messages from the mix of Chinese FDI statistics 45 i

4 4.2 A positive reversal on FDI and ODI A focus on transit countries 50 5 FOCUS ON CHINA S CURRENT ACCOUNT DYNAMICS AND MEDIUM-TERM PROSPECTS Introduction: Historical current account dynamics Current Account: An alternative perspective Forecast: Internal rebalancing to erode current account surplus References 64 ii

5 1 Key Messages The EU-China Economic Observatory provides a large range of factual and analytical information, both on very short-term evolutions and on the medium-term background in which any such short-term changes take place. The key messages derived from this report are the followings: Cyclical Analysis The cyclical outlook for China is currently highly uncertain, with a shift in policy direction putting more importance to credit control and less on achieving a higher GDP growth rate. Activity should however pick up very modestly in the second half of 2013 before slowing down again in 2014, with a range of 7.0%-8.0% likely over the coming quarters. Risks remain concentrated on the impact of such growth outlook on corporate profitability, indebted economic agents (including local governments) and the banking system. The recent tensions in interbank liquidity suggest that some weaker financial institutions highly active in the shadow banking system may face more acute funding problems. The resilience capabilities of China remain however very strong, and the simple fact that the labor market remains tight means that reflation policies will in all cases remain limited. In a context of depreciating competing currencies and a mediocre international trade environment, the pace of CNY appreciation against the USD may slow down over the coming months. China s structural rebalancing remains under way, with household-driven demand progressively contributing to a higher share of overall growth, even though the pace at which consumption can accelerate cannot compensate the risks of a more brutal decline in investment spending. Trade Monitor Recent trade performances show a moderate rebound in Chinese exports compared to 2012H1, while the growth in China s import has remained more subdued, leading to a new phase of widening total trade surplus during the first five months of China is still gaining market shares on world imports, but the country is also continuing to see its imports developing faster that total exports from the rest of the world. Trade performances in the early months of 2013 have been however very volatile, more than what the usual issues related to the Lunar New year would suggest. The increasing surpluses and changes in domestic policies regarding domestic competition and risks on excess capacities have led to an increasing number of trade frictions and disputes involving China, with the EU as one of the key plaintiff. Trade data issues have resurfaced during the last months of 2012 and first half of 2013, but our analysis suggests that such data discrepancies between Chinese and foreign statistics imply much more complex questions than just export over-invoicing in order to circumvent capital controls. The role of Hong Kong and to a lesser extent Taiwan in China s export processing and insertion into global chains are likely to play a key role in explaining data differences. With final demand in the EU still very weak and the US recovery on a soft path, China s trade diversification has continued at a rapid pace, with emerging economies being both the fastest growing markets and the fastest growing suppliers. On the (Chinese) import side, the lower demand and lower prices of most commodities have led to visible decline in imports from key commodity producers (e.g. Brazil and Russia). In terms of products, equipment goods (electric / electronic as well as mechanical) A report written by TAC - Applied Economic & Financial Research 1

6 have kept a very rapid growth rate, accelerating the changes in China s structure of total exports, with traditional product clearly taking a back seat in overall trade dynamics. The analysis of US and EU historical trade figures with China suggest a similar integration of China on the European and US markets. But if the recent performances of Chinese exports to EU and US confirm the overall slowdown of demand from both partners, the relative contribution of US-China trade balance in total Chinese trade surplus has been growing. The strong decline in exports and imports growth rates has stopped, but if the EU-China trade deficit has slightly and regularly decreased, the magnitude of the reduction remains limited. Concentration among EU Member States for exports to China, larger diversification of EU Member States for exports. Increasing prevalence of China as a major trade partner for EU Member States in last decade, with more ambiguous dynamics in 2011 and Investment Analysis Various sources record FDI in and out of China, and their methodology widely varies, providing a muddled picture about FDI in China. Based on an in-depth research, the main explanations of such differences can be explained by either additional components in FDI statistics (ex: China classifies in BOPS statistics imported equipment as FDI and include a substantial amount of round tripping), or important gaps between some component such as the recording of reinvestments of earnings. Despite huge gap between FDI statistics, several key messages can be drawn: (1) the catch-up of ODI over FDI in China over the recent years, (2) the increase in reinvestment of earnings in China while the equity and investment fund shares (i.e. the real new FDI ) modestly decreased since the Global Financial Crisis. (3) This increase in reinvestment of earnings is explained by a combination of two main reasons: serving the domestic market in a context of market access difficulties, implying that foreign investors try to increase market share in China through their local affiliates. COFM figures for 2013Q1 confirm the rebound in global FDI inflows and outflows observed since 2012Q3. However, this increase is mostly concentrated on a small number of very large deals (this is again true for both inflows and outflows). MOFCOM figures suggest that Hong Kong is by far the main FDI partner of China but the statistics lack of transparency (including important round-tripping effect etc). Focusing on real new FDI, COFM figures draw a very different picture than MOFCOM. The figures show that foreign countries generally invest in China without transiting by another country. But the phenomenon tends to decline over the recent years, compensated by an increase in investments through local affiliates (20% of the number of operations in 2012). Hong Kong serves as transit for less than 3% of foreign operations in China, while the share of China FDI abroad transiting by Hong Kong increased to 6%-8% over the period In general, similar strategies are used by investors into and out of China with a significant part of deals operated through their subsidiary in the biotechnology, the real estate, the energy and food & beverages. Conversely, companies choose to directly invest (from the ultimate parent) in the electronic/software/it, the chemicals, the healthcare and services, assuming easier access in such markets. Focus on China s current account dynamics and medium-term prospects After closely following investment, aggregate savings (% of GDP) surged from 2000 onwards in two distinctive stages: and The strongest gains were recorded during the first period and it peaked in the second at above 50%. The trade deficit in oil since 2003 has considerably widened, particularly after 2008, and appears to have stabilized in Meanwhile, the trade shortfall in Ores, Slag and Ash as well as Copper and articles thereof has steadily grown over the past three years. Compared to all its trade partners, China generally has the largest trade deficits with commodity producers. Australia, Saudi Arabia, Angola, Malaysia, and Brazil are among the top 10 trade deficit A report written by TAC - Applied Economic & Financial Research 2

7 markets. Since 2001, Angola has observed the strongest deficit expansion while India displays the most notable surplus expansion with China. Over the past five years, the drastic drop in the current account seems to root from a combination of factors, including elevated investment levels, a weak global environment, and commodity price gains that have generally outstripped export price advances. A decline in savings will help to rebalance the internal and external imbalance; however, this will be difficult if investment decreases at a faster rate. Historical precedence highlights generally two types of rebalancing episodes: (1) crisis and (2) gradual transition (e.g. Taiwan and Japan). The latter category offers examples of mixed success. An attempt to rectify the internal and external imbalance is expected to apply downward pressure on China s current account surplus over the medium-term, averaging slightly below 1% over the course of the 12th 5-Year Plan ( ). This will appear to have a relatively negligible impact on the EU s trade balance with China whereas a deficit expansion is expected for the US. Meanwhile, Korea is set to see the pace of expansion in its trade surplus with China stagnate, following four years of robust gains. A report written by TAC - Applied Economic & Financial Research 3

8 2 China s cyclical performance This chapter of the Observatory Report aims at looking at the recent macroeconomic information available on China s cyclical performances and assessing the main issues relating such performances with China s trade and investment developments. The first section of the chapter provides TAC s view on short-term cyclical issues and outlook, which in this Issue is based on TAC s proprietary quantitative tool for country risk measurement. A second section summarizes the consensus view on China s short-term economic outlook, using a monthly survey of expectations by about 20 financial institutions, multilateral agencies and industrial companies on current and next year s economic performances. Finally, a third section is a summary table of key cyclical indicators for the Chinese economy. Key Elements The cyclical outlook for China is currently highly uncertain, with a shift in policy direction putting more importance to credit control and less on achieving a higher GDP growth rate. Activity should however pick up very modestly in the second half of 2013 before slowing down again in 2014, with a range of 7.0%-8.0% likely over the coming quarters. Risks remain concentrated on the impact of such growth outlook on corporate profitability, indebted economic agents (including local governments) and the banking system. The recent tensions in interbank liquidity suggest that some weaker financial institutions highly active in the shadow banking system may face more acute funding problems. The resilience capabilities of China remain however very strong, and the simple fact that the labor market remains tight means that reflation policies will in all cases remain limited. In a context of depreciating competing currencies and a mediocre international trade environment, the pace of CNY appreciation against the USD may slow down over the coming months. China s structural rebalancing remains under way, with household-driven demand progressively contributing to a higher share of overall growth, even though the pace at which consumption can accelerate cannot compensate the risks of a more brutal decline in investment spending. A report written by TAC - Applied Economic & Financial Research 4

9 2.1 A country-risk approach to the current economic situation in China For this Issue of the EU-China Economic Observatory, we chose to apply to China a specific set of quantitative models designed by TAC to assess and measure the degree of country risk in developing and emerging economies. Country risk is defined as risk of cyclical difficulties, of currency depreciation and of cross-border payments. TAC s tool, called RiskMonitor, uses a combination of non-linear statistical techniques, from combinatorial approach with threshold effects to neural networks, and the risk ratings have an optimal horizon of about 2 years ahead. The main conceptual and technical characteristics of RiskMonitor are summarized in Box 1. The approach is based on the reading provided by six Fundamental Balances, each illustrating China s path seen from one specific angle of country risk. Two of the Fundamental Balances are structural, i.e. look at trenddeformation in terms of growth and external financing. The next two are looking at short-term external questions and the last two look at short-term domestic issues. The results are in the form of Economic & Financial Risk Ratings (a global as well as currency, activity and payment ratings). In the analysis below, we start by looking at the individual Fundamental Balances and complement with more analytical or parallel views and analysis. Economic & Financial Risk Ratings Box1: RiskMonitor Methodology Country Ratings measure the likelihood of economic or financial difficulties. They are determined through a normative approach: the countries performances on each of the Fundamental Balance (called Scores) are estimated quantitatively with non-linear algebraic functions; then, the Country Ratings are computed through weighted geometric means of the 6 Scores. The Country Ratings are continuous on a scale from 0 to 100, grouped in four categories (A-B-C-D), and are differentiated for three different types of economic / financial difficulties (payment, exchange rate, economic activity) and three time-horizons (less than 1 year, 1 to 3 years, and 3 to 5 years). Economic Risk Crisis Signals Growth Balance Real GDP, current account, Debt Balance External debt, FDI Liquidity Balance Short-Term debt, rfx level Exchange Rate Balance Currency overvaluation, rfx dynamic Cyclical Balance Business cycle, monetary policy Banking System Balance Domestic credit, intern. refinancing Crisis Signals warn of upcoming full-blown crises. The 12 economic and financial indicators, both actual and over the previous periods, are treated by five different non-parametric models, all of them focusing on signaling outputs and designed to capture non-linearity between variables. The results are flags indicating a high probability of, or a high vulnerability to, adjustments of such a magnitude and violence that they can significantly alter contractual commitments and counterparties financial health in an indiscriminate way. Mirroring the Economic Ratings, the Signals are provided for 3 types of shocks (transfer crisis & default, currency collapse, violent recession) and 3 horizons. A report written by TAC - Applied Economic & Financial Research 5

10 2.1.1 Key findings The key messages delivered by RiskMonitor on China are as follows: The combination of performances on the six Fundamental Balances reveal a moderate degree of risk for China, but with a clear dichotomy between balances that are exceptionally favorable (Growth, Debt and Liquidity) and those which are mediocre (Banking System, Cyclical and to a lesser extent Foreign Exchange), and a visible deterioration over the past two years. The average Economic & Financial Risk Rating remains at a very comfortable 41.8 (on a scale from 0=lowest risk to 100=highest risk), but has deteriorated by almost 10 points over the past 2 years. So far, there is no Crisis Signal indicating probability of systemic shock over the next few years. TAC RiskMonitor China - Economic & Financial Risk Rating History from 0 (lowest risk) to 100 (highest risk) Indeed, China is very firmly positioned in the low risk area in the Growth Balance, indicating a very strong ability to register sufficient growth while keeping positive external accounts; similarly, a very limited recourse to foreign currency debt and very large inflows of foreign direct investment put the country in the lowest risk position of the Debt Balance. Finally, the abundance of foreign exchange reserves and limited short-term foreign currency liabilities ensure again a very low risk position for the Liquidity Balance. The strengths of these three Balances give China major resilience capabilities if or when faced with either exogenous shocks or the consequences of China s structural transformations. Symmetrically, three of the shorter-term Balances show intermediate risk positions (but none is in the high risk area). The Banking System Balance reveals an excessive domestic leverage even before taking into account the rapid increase in funding from the shadow banking system, suggesting that banks are more sensitive to the current economic slowdown than currently measured through the low level of nonperforming loans. This is reinforced by the signal of a very modest uptick in economic growth over the next quarters or years shown by the Cyclical Balance. The position in a very moderate unsustainable overvaluation in our Foreign Exchange Balance shows both the increasing pressure related to movements of capital despite the persistence of capital controls and the loss in competitiveness triggered by the depreciation of many competing currencies. This position suggests a greater caution in terms of future Yuan appreciation, especially if the Japanese monetary policy was to trigger a chain of competitive devaluation in Asia. A report written by TAC - Applied Economic & Financial Research 6

11 RiskMonitor Fundamental Balances for China, June 2013 The risks appear to be concentrated on corporate and financial risks, especially for companies having taken a large debt load and seeing their gross margins eroded by the unavoidable increase in the share of wages in total value addition. The likelihood of increased bankruptcies or financial difficulties will have a bearing on banks and financial institutions, with second-tier banks increasingly vulnerable, including to the recent tightening in interbank liquidity conditions. Combining this country risk approach to our usual monitoring of the Chinese economic developments allow providing a synthetic view on the short-term outlook for China as well as the country s medium-term challenges: Macroeconomic performances in China have been exceptional over the past decade, with low inflation, high growth, large external surpluses and a balanced budget balance, all associated with a significant improvement in infrastructure and a major decline in poverty. Such results were related to a development model making full use of the huge demographic transformation during the past period combined with a massive accumulation of capital and a successful strategy of integration into global production chains. In this context, China was well equipped to cope with the global economic crisis of with a massive plan to budget support and a quick reversal of the monetary policy. However, all the ingredients for the Chinese development path are now changing rapidly, from an ageing process that has no equivalent in human history, a need to absorb excess capacities (and some dubious investments in infrastructure) while the international environment is less favorable and trade patterns are gradually shifting towards more regional supply chains. Such changes are creating very significant challenges, which have been clearly identified by the Chinese authorities: move towards a more household-driven demand, improve quality and innovation while taking into consideration the critical environmental problems, and increase the efficiency of capital spending. Over the short-term, the structural transformation is associated to difficult policy management, as export growth and industrial investment are slowing down while private consumption cannot immediately take up the resulting slack in demand. The result is a delicate balance between support to infrastructure and public spending, and monetary control on the real estate bubble, leading to lower GDP growth. With priorities being shifted towards a greater control on credit distribution and the shadow banking system, this suggests a stabilization in GDP growth in-between 7.5% and 8% over the next few quarters and a further slowdown over the medium-term. A report written by TAC - Applied Economic & Financial Research 7

12 This slowdown is not creating direct risks on the labor market because of the ongoing shifts in demographic structure, but may induce more pronounced difficulties for the corporate and the financial sectors. Over the longer run, the questions of improving social conditions, transformation of financial intermediation, reduction in aggregate credit leverage and the absorption of increasing urbanization are significant issues with mechanical uncertainty about the political capacity to ensure continuous balance in these structural changes Growth Balance The Growth Balance measures the ability of a country to register a sufficient economic growth without triggering unsustainable external imbalances. Chinese Structural Balances are extremely favorable, with high economic growth supported by internal and external demand, coupled with large current account surpluses and a low level of external debt. Positions on the Growth and Debt Balances are firmly anchored in the area of low risk even though the path on the Growth Balance illustrates a structural shift towards lower economic expansion. China has benefited from "structural" effects of very strong investment spending including record amounts of foreign direct investment (FDI), greatly increasing the country's overall competitiveness and ensuring rapid integration into international production chains (clothing, goods electronic) as well as a catch-up in terms of technology and know-how. Simultaneously, Chinese companies were able to increase their profitability, partly due to higher margins on international markets, enabling a substantial funding of the massive domestic investment effort. This combination has put China s path in the Growth Balance in an exceptionally favorable position from the mid-90s to the mid-2000s. The global / EU crises however revealed the presence of excess capacities and reduced profitability, fueling the need for the so-called structural re-balancing towards more household-driven demand and pushing the Chinese path towards a still favorable but less exceptional part of the low risk area during After a relatively strong showing in 2012Q4, economic activity expectedly eased in the subsequent three months with Chinese New Year festivities falling towards the end of February. Given the alternation of the holiday from one year to the next, year-on-year figures are often distorted during the first quarter of the year. April and May data releases have thus far pointed to stabilization in growth, if not a slowdown, for 2013Q2. Aware of this reality and in line with the 12 th Five-Year Plan, the authorities have conveyed comfort with sub 8% GDP growth, targeting of 7.5% for this year and an average of 7% for the period This has been A report written by TAC - Applied Economic & Financial Research 8

13 accompanied by initiatives to reduce administrative red tape and other regulatory barriers to entry. The external sector has likewise been unable to avoid this fate. After correcting for discrepancies in April s export statistics, the pace of outbound shipments turned south from 14.7% y/y in the previous month to 1% y/y in May. Similarly, import gains saw a sharp drop from 16.8% y/y to -0.3% y/y, partly reflecting weak domestic consumption conditions. Overall however, the rebalancing is visible in quarterly GDP statistics, with the share of household-driven demand (including consumption and residential investment) estimated to contributed to about two-third of the total GDP growth over the past four quarters (2012Q2 to 2013Q1). China: contribution to quarterly GDP growth Source: TAC from NBS According to Consensus Forecasts, the current account surplus is envisaged to remain relatively steady at USD 232bn for this year, up slightly from USD 213.8bn in 2012, stemming from a subdued advance in both exports and imports. GDP growth is expected to come out in the range of % in 2013, heralding a structural shift towards an estimated 6.5%-7.0% potential growth for the remainder of the decade (see estimates of long-term potential output growth in the chart below). Notwithstanding this slowdown, China s position in the low risk area of the Growth Balance is not threatened over the short- to medium-term. A report written by TAC - Applied Economic & Financial Research 9

14 2.1.3 Debt Balance The Debt Balance allows analyzing the specific external solvency issues of a country. It measures the structural quality of a country s external financing and its ability to balance debt with more stable inflows of foreign direct investment. China is firmly entrenched in the low risk position since the early 2000s. The accumulation of large current account surpluses (USD 2,150 bn over the past 10 years) and massive FDI (a cumulative USD 1,350 bn over the same period) has severely limited the use of debt in foreign currency (USD 685 md end 2011, 30% of current account revenues). As a result, the indicator of debt service is exceptionally low, although it has sharply increased in absolute amounts since 2010 (from around USD bn per year to USD bn in 2010 and 2011). Meanwhile, the stability of funding remains very high thanks to the high flow of FDI. We observe however that the amount of ODI (outward foreign investment from China to the rest of the world) have been increasing steadily, almost at par with inward FDI since It should also be noted that, from the perspective of an external creditor, the external debt is low for China, but often represents a significant exposure of lenders, thus creating a "balance of power" undoubtedly more favorable to the debtors. A few small uncertainties, however, remain about flows of speculative capital, due to expectations related to the appreciation of the Yuan, which focus on the financial and real estate markets. But given the low external debt level combined with the local currency s growing strength, there is little concern regarding the country s vulnerability to a capital reversal. A report written by TAC - Applied Economic & Financial Research 10

15 As long as the capital account remains essentially closed, the vast majority of funding will likely continue to be domestically sourced, however, with the recent 12 th Five-Year Plan identifying capital account liberalization as one of its target objectives this financing dynamic will unlikely survive the next decade, implying an eventual northward transition within the low risk quadrant Liquidity Balance The Liquidity Balance assesses the foreign currency situation of a country by looking at the relative magnitude of currency reserves and short-term foreign currency liabilities. The Short-Term External Balances have a somewhat less favorable position, with deterioration in the forex reserves quality in conjunction with the growing importance of capital flows coinciding with some losses in external competitiveness on the Foreign Exchange Balance, compensated however by a very comfortable position in the low risk area on Liquidity Balance. China s trajectory in the Liquidity Balance reveals a very high level of foreign exchange reserves held by the central bank associated with limited recourse to short-term foreign currency funding. Indeed, our indicators of forex liquidity and maximum potential service are moving very far from the risk thresholds of this Balance, giving China huge reaction capabilities in times of tensions either domestic (e.g. banking) or external (e.g. financial volatility). A report written by TAC - Applied Economic & Financial Research 11

16 Short-term liabilities in foreign currencies have risen sharply in absolute amounts since the early 2000s (from USD 88 bn in 2003 to USD 477 bn at the end of 2011 according to the World Bank), but this is fully consistent with the increase in the country s trade financing needs (quarterly imports are around USD 450 bn). In parallel, forex liquidity remains very strong. Total foreign exchange reserves were at USD 3,311 bn at the end of 2012, further increasing to USD 3,441 bn at the end of March The movement of the indicator, towards the left since 2011Q1 indicates however that the pace of reserve accumulation is now slightly lower that the increase in China s economy (as we measure the reserves against domestic indicators), and that capital outflows occur on a larger scale. It should also be noted that there are uncertainties on the actual amount of immediately available reserves held by the People s Bank of China (PBoC, the central bank) as part of the reserves have been allocated to the Chinese sovereign Fund (CIC, for an amount estimated at USD 600 bn), which is clearly investing abroad in non-liquid assets. Overall, issues and potential difficulties in China are not related to potential fx liquidity needs, but to the management of the fx reserves and its impact on the economy and on the country's international relations. Concerns related to the accumulation of U.S. T-Bonds associated with a weaker dollar made the gradual diversification of reserves an important goal. This also motivates partially the accelerated actions towards the internationalization of the Yuan and the facilitation of international trade transactions in the Chinese currency since A report written by TAC - Applied Economic & Financial Research 12

17 The decision to resume the gradual appreciation trend of the Yuan against the dollar (after two years of fixed exchange rates) should ultimately reduce the difficulties induced by the policy of controlling the exchange rate (sterilized interventions and arbitrage against domestic monetary policy objectives), but the adjustment will be very gradual Foreign Exchange Balance The Foreign Exchange Balance looks more at the relative valuation of the exchange rate in terms of international competitiveness as well as at the dynamics of official foreign currency reserves against international interbank lending and domestic monetary aggregates. On the Foreign Exchange Balance, these changes in capital flows explain a less favorable picture. Up to 2008Q2, the trajectory is concentrated in the center of the chart, with frequent but small movements on both axes. This suggests on the one hand, a neutrally competitive exchange rate (albeit with huge differences in productivity between foreign-funded enterprises and a domestic ones), and a less favorable quality of foreign exchange reserves than the quantity measured in the Liquidity Balance. Since 2008 and the global financial crisis, China s path has substantially changed, with much larger movements on the forex reserves quality index (major improvement in 2009, substantial deterioration in 2011, new but lower improvement in 2012) and regular moves of the exchange rate competitiveness above the neutral valuation thresholds (end of 2008 and 2009, and again since early 2012). The former is indeed reflecting a growing importance of short-term speculative capital flows, and the latter is revealing the negative impact of the CNY appreciation (albeit modest) when competing currencies were depreciating. The CNY has steadily appreciated since mid-2012, exhibiting two phases. The first phase saw the USD/CNY rate generally appreciate by about 1%. The pace accelerated after February Shortly after, within the next three months, the Yuan strengthened by about 1.5%. In fact, since March it has been appreciating at an accelerating rate. Relative to other currencies over the past three months, the CNY and a handful others have showed positive gains against the USD, which serves as evidence that the Yuan s competitiveness is weakening. A report written by TAC - Applied Economic & Financial Research 13

18 There appears to be a psychological barrier between USD/CNY under which the authorities are expected to intervene, notwithstanding the fact that the PBoC has signaled that it will permit the currency to appreciate modestly further this year. Coupled with the recent depreciation of most emerging markets currencies (therefore reducing the CNY competitiveness), this should result in a northward move for the local currency and a deeper position in the unsustainable overvaluation quadrant towards the end of the 2013H1. In turn, this suggests that the pace of appreciation may slow down (or stop) over the coming months or quarters, unless EM currencies re-appreciate after the recent turmoil. Meanwhile, the improvement in forex reserves quality throughout 2012 appears set to slowdown, if not reverse, stemming from the fact the pace of exports has thus far waned in Q2. This will likely dampen forex reserve gains and further disconnect the pace of change on foreign exchange reserves with that of domestic liquidity. With exchange rate competitiveness eroding and the improvement in forex reserves quality stagnating, it is likely that the fundamental risk score on the Foreign Exchange Balance will show some deterioration towards around mid A report written by TAC - Applied Economic & Financial Research 14

19 TAC RiskMonitor Short Term domestic Balances highlight the most sensitive component of China s country risk, with a record level of domestic leverage on the Banking Balance, and a very modest uptick in the real economic pressure index in the Cyclical Balance accompanied by a neutral monetary stance, suggesting softness in future domestic demand developments Cyclical Balance The Cyclical Balance gives a view of the cyclical position in a country risk perspective, and allows a measure both of the quality of the domestic economic policy and of the nature of the most sensitive risks, by looking at the de facto stance of the monetary policy and the momentum of domestic activity. In each of the four areas, the risk is growing when the country is moving towards the corner of the chart. The movements of China in our Cyclical Balance reveals two important structural characteristics: first, the changes in our monetary pressure index remains rather limited, with values most often in-between the two secondary risk thresholds, suggesting a rather neutral monetary policy and therefore very limited risks of sustained inflationary pressures. The only moments when China s path exits this neutral positions is when authorities react to a highly negative external shock (expansionary monetary policies, e.g. 2009) or when exogenous price pressures put a risk on domestic inflation (restrictive policies, e.g. early 2008). Second, changes in the real economic pressure index are much larger and suggest that the ability to manage domestic demand dynamics is still partially compensated by the influence of the international environment on export growth and subsequently investment spending. Over the recent past, China s cyclical path has been characterized by a large decline (after the post-financial crisis rebound up to the beginning of 2011) in the real economic pressure, indicating the slowdown in GDP, with a monetary reflation that has been very modest, especially when compared to the policies put in place in The last point on the chart (2012Q4) shows the first reversal in the leading index, after 2 quarters when the declines became very small: this is indeed suggesting that economic activity should stop decelerating in 2013H2 and early 2014, but the position far below the neutral thresholds also strongly confirms that such a pick-up will remain very mild. In parallel, the monetary pressure has exhibited the first signs of decline, highlighting the Chinese authorities desire to rein-in credit distribution. This policy is also behind the recent tensions observed in interbank rates, where PBoC engineered spikes are probably targeting the unregulated financial institutions operating in the so-called shadow banking system, which rely heavily on interbank funding. A report written by TAC - Applied Economic & Financial Research 15

20 Although there appear no indications that growth will fall below 7.5%, the moderation in growth during the first three months of the year appears set to continue into Q2. Inflation has essentially stabilized within the 2% range from March 2013 to May (2.1% y/y). In fact, aside from the jump in February, it has fluctuated between % y/y since December Moreover, producer prices have fallen from -1.6% y/y in January to -2.9% y/y in May. Nonetheless, the pace of deflation has been easing over time and appears to be reaching a bottom. The general moderation in inflationary pressure is being supported by CNY strength. Overall, China s economy is stabilizing around 7.5% y/y growth, below-10% industrial production growth and inflation clearly below 4%. In light of this fact, the next move by China on the Cyclical Balance may is likely to be towards the pressure on corporates quadrant, very much in line with the structural analysis of medium-term pressures on gross corporate margins. A report written by TAC - Applied Economic & Financial Research 16

21 Source: Credit Suisse Banking System Balance The Banking System Balance (G6) gives a measure of the risks associated with imbalances in the overall banking situation of the country, through an appreciation of the links between activity and banks health on one hand, and the dependence of domestic banks on foreign financing on the other hand. The Banking System Balance indicates a very high domestic leverage, with bank loans up to USD 12,808 bn at the end of 2012 (155% of GDP) and strong growth until the end of Even before taking into account the extra leverage provided through the shadow banking system (difficult to estimate because of double counting, but probably around 35% to 40% of GDP), such a level of leverage in a country still in the process of development is a major source of risk over the medium-term. This is partly compensated by the dominant reliance on domestic funding by Chinese banks, as shown by the very low value of our foreign funding indicator. Added to the persistent dominant share of bank loans by State- Owned Banks and the dominant share of loans taken by State-Owned enterprises, this suggest that any A report written by TAC - Applied Economic & Financial Research 17

22 systemic tensions can be met by the authorities, even though such a reaction would mechanically increase substantially the total public debt, well above the (officially reported) ratio of 30% to GDP. The combination of the uncertainties on property prices, the economic slowdown and "excess" investments operated through socalled Special Purpose Vehicles set by local governments to fund infrastructure projects, the likelihood of a sharp rise in non-performing loans in all Chinese banks is very high, and the possibility of having a couple of second-tier institutions getting into very serious solvency issue is real. According to an ECB study, under nonextreme scenarios, the burden of NPLs over time would amount to somewhere between 9% and 14% of 2010 GDP. These figures are considered manageable. Even under a pessimistic scenario the new NPLs would be about 8% of GDP in This suggests increasing differentiation across banking institutions, with weak ones as well as those most exposed (directly or indirectly) to the shadow banking system having a high to very high risk, while the large ones and especially the four biggest SOB (ICBC, CCB, BOC and ABC) being assimilated to a much lower sovereign risk. 2.2 Consensus outlook for China According to the Consensus Outlook (June 2013 issue), China s economic performances will register an overall stabilization in 2013 and 2014 with GDP growth estimated so far at +7.8% for both years, equivalent to the growth achieved in Investment growth would slow down further in 2014, albeit modestly, while consumption spending would accelerate, also modestly A report written by TAC - Applied Economic & Financial Research 18

23 Consensus Outlook for China Domestic Growth Exports are expected to increase (in dollar terms) in 2013 (USD 2258 bn, +10.2%) and 2014 (USD 2482 bn, +9.9%), with a parallel increase in imports (USD 2002 bn, +10.1%, and USD 2230 bn, +11.3%, respectively for 2013 and 2014), leading to a modest increase in China s overall trade surplus in 2013 compared to 2012 (respectively USD 231 bn and USD 256 bn) before stabilizing in 2014 (USD 252 bn). The current account surplus would remain roughly stable around USD bn. In relative terms (i.e. compared to China s GDP), the external surpluses are therefore expected to decline during these two years. Consensus Outlook for China External Balances (bn USD) Divergences between analysts (minimum and maximum values) for 2014 are very large for retail sales, and exceptionally high for the current account balance (with the lowest estimate at USD 90 bn and the highest at USD 321 bn). This measure of divergence highlights the current degree of uncertainty weighting on Chinese economy for 2013 and A report written by TAC - Applied Economic & Financial Research 19

24 Measures of convergence / divergence in the June 2013 Consensus Outlook for China 2013 (f) 2014 (f) 2013 (f) 2014 (f) GDP -average Exports -average max max min min Divergence 9% 15% Divergence 5% 13% Jan 2013 Divergence 20% 23% Jan 2013 Divergence 10% 18% Retail sales -average Imports -average max max min min Divergence 49% 56% Divergence 10% 15% Jan 2013 Divergence 46% 61% Jan 2013 Divergence 10% 20% Investment -average CA balance -average max max min min Divergence 21% 31% Divergence 62% 106% Jan 2013 Divergence 27% 36% Jan 2013 Divergence 108% 200% Source: Consensus Inc., TAC 2.3 Summary of China s cyclical indicators The following table provides some of the most important economic indicators to monitor China s short-term development. Sources are both domestic (China-on-line Database, People s Bank of China, National Bureau of Statistics, MOFCOM) and international (World Bank, International Monetary Fund). Key cyclical economic indicators for China Jul. 12 Aug. 12 Sep. 12 Oct. 12 Nov. 12 Dec. 12 Jan. 13 Fev. 13 Mar. 13 Apr. 13 May. 13 Jun. 13 Consumer Prices (y/y, %) Producer Prices (y/y, %) Industrial Production (y/y, %)) Fixed Investment (y/y, %, accumulated from Jan.) Retail Sales (y/y, %) NBS PMI HSBC PMI Exports (bn usd) y/y growth (%) Imports (bn usd) y/y growth (%) A report written by TAC - Applied Economic & Financial Research 20

25 Jul. 12 Aug. 12 Sep. 12 Oct. 12 Nov. 12 Dec. 12 Jan. 13 Fev. 13 Mar. 13 Apr. 13 May. 13 Jun. 13 Trade Balance (bn usd) Forex Reserves (bn $) Reserves (mths of imports) y/y growth (%) Exchange rate CNY/USD Exchange rate CNY/EUR Real Effective Exchange Rate y/y growth (%) Money Supply (M2) (y/y, %) Financial Institutions Loans (y/y, %) Interest rate (1-year deposit, %) Reserve Requirement Ratio - Small Banks Reserve Requirement Ratio - Big Banks Lending Rate Shanghai Stock Index y/y growth (%) House Prices Index (y/y, %) Credit Default Swap 5 year Source: Datastream, National Bureau of Statistics of China, IFS, China Customs Statistics A report written by TAC - Applied Economic & Financial Research 21

26 3 China s trade monitor This section provides a comprehensive analysis on key issues of China s external trade, with a particular emphasis on short-term perspectives and challenges. We look at the detailed quantitative changes in trade performances, globally and by trading partner, and also with a product analyses. In addition, we present the relevant features and changes in bilateral trade between China and the EU. Key Messages Recent trade performances show a moderate rebound in Chinese exports compared to 2012H1, while the growth in China s import has remained more subdued, leading to a new phase of widening total trade surplus during the first five months of China is still gaining market shares on world imports, but the country is also continuing to see its imports developing faster that total exports from the rest of the world. Trade performances in the early months of 2013 have been however very volatile, more than what the usual issues related to the Lunar New year would suggest. The increasing surpluses and changes in domestic policies regarding domestic competition and risks on excess capacities have led to an increasing number of trade frictions and disputes involving China, with the EU as one of the key plaintiff. Trade data issues have resurfaced during the last months of 2012 and first half of 2013, but our analysis suggests that such data discrepancies between Chinese and foreign statistics imply much more complex questions than just export over-invoicing in order to circumvent capital controls. The role of Hong Kong and to a lesser extent Taiwan in China s export processing and insertion into global chains are likely to play a key role in explaining data differences. With final demand in the EU still very weak and the US recovery on a soft path, China s trade diversification has continued at a rapid pace, with emerging economies being both the fastest growing markets and the fastest growing suppliers. On the (Chinese) import side, the lower demand and lower prices of most commodities have led to visible decline in imports from key commodity producers (e.g. Brazil and Russia). In terms of products, equipment goods (electric / electronic as well as mechanical) have kept a very rapid growth rate, accelerating the changes in China s structure of total exports, with traditional product clearly taking a back seat in overall trade dynamics. The analysis of US and EU historical trade figures with China suggest a similar integration of China on the European and US markets. But if the recent performances of Chinese exports to EU and US confirm the overall slowdown of demand from both partners, the relative contribution of US-China trade balance in total Chinese trade surplus has been growing. The strong decline in exports and imports growth rates has stopped, but if the EU- China trade deficit has slightly and regularly decreased, the magnitude of the reduction remains limited. Concentration among EU Member States for exports to China, larger diversification of EU Member States for exports. Increasing prevalence of China as a major trade partner for EU Member States in last decade, with more ambiguous dynamics in 2011 and A report written by TAC - Applied Economic & Financial Research 22

27 3.1 Overview of China s trade performances and challenges The following section provides a brief summary of China s trade performances for 2012 and an update analysis using data up to April 2013 released by the General Administration of Customs of China. A synthetic review of major trade policies and questioning development in recent statistical release are also presented China s trade performances and dynamics After the dual feature observed in 2012 (moderation in trade dynamics on annual basis but with record level of trade performances), China s most recent data indicate a visible rebound in trade dynamics leading to impressive trade performances in Jan.-May 2013, notwithstanding a significant persistence in volatility of monthly dynamics due to both domestic and external factors (since bilateral trade dynamics reported by China Customs Statistics are not matched by standard discrepancies in statistical releases of key trade partners, a more detailed analysis of potential shortcomings in trade performances and dynamics will be assessed in following sub-section). Regardless of the statistical accuracy issue, exports have registered a stronger acceleration to reach USD 879 bn in Jan.-May 2013 (i.e % y/y); while imports have moderately accelerated by +8.1% y/y to USD 797 bn. As a consequence, the reversal to upward trade balance accumulation observed in 2012 is accentuated over the five first months of 2013 (accumulated trade surplus more than doubled an annual basis to USD 82 bn). China s Trade Performances since 2008 Exports Imports Trade Balance USD bn y/y change USD bn y/y change USD bn % % % % % % % % % % 231 Jan.-May % % 37 Jan.-May % % 82 Sources: CCS, TAC A report written by TAC - Applied Economic & Financial Research 23

28 China s Annual Trade Performances since 2000 Monthly performances of exports and imports have reached a new plateau in recent months. In May 13, exports are registering their third consecutive month above USD 180 bn; and in Jan. 13 and Apr. 13, monthly exports (USD 187 bn each) stood in the top three best months of exports, only after historical record of USD 199 bn in Dec In parallel, imports have reached a new highest level of USD 183 bn in Mar. 13, 9% higher than the earlier best monthly performance (Dec.20 12). This impressive level is capturing the impact on Chinese s New Year on trade volatility. Indeed, the month-on-month (m/m) imports decline of -22% in February (-15% y/y) was followed by a 47% m/m surge in March. Another interesting feature related to trade dynamics around the Chinese s New Year is the increased volatility; however in 2013, the seasonal trough of exports and imports annual percentage change (as in 2011 and 2012), is associated with a substantial volatility only in imports dynamics (plunge in Feb. 2013). Exports grew by 22% y/y in Feb. 2013, against -0.5% y/y in Jan and +2.2% y/y in Feb In addition, the China s trade growth slowed down sharply in May; exports inched up merely by 1% y/y, while imports declined by 0.3%. The smoothened dynamics of trade (3-month moving average of export and import growth rates) is characterised by a progressive and extended slowdown between 2010 and Sep.-Oct This suggested the emergence of new structural trade cycle in China, supported by the ongoing domestic shift in economic growth model, but also highlighted the persistent stuttering economic conditions in the EU and the US. The achievement of very low point in the smoothened trade trend has been followed by a significant rebound in imports and exports dynamics (to +12% y/y in Jan. 13 and +20% y/y in Feb. 13 respectively). Eventually, the momentum of exports and imports dynamics plunged to a minimum level in May 2013 (+1.0% and -0.3% on annual basis respectively), potentially arising from correction in impressive trade dynamics in the previous months, and leading to a joining of both 3-month moving average of export and import growth rates. Over a longer horizon, this downward trend in trade dynamics is also evidenced in the slowdown in 12-month rolling average of exports (+10% y/y in Jun. 12-May 13 against 14% y/y in Jun. 11-May 12) and imports (5% against 15% on annual basis over similar periods). In addition, this suggests that the recent pick up in trade dynamics is temporary, especially if fuelled by inflation of trade figures by China s Customs Statistics; and the slow growth of the global economy, in particular in developed European economies, is delivering an adverse and sustained impact on the external demand for China s goods. A report written by TAC - Applied Economic & Financial Research 24

29 China s Monthly Trade Performances since 2011 China s Monthly Trade Dynamics since 2011 At the global scale, China s trade dynamics has regularly outpaced the global trade dynamics in recent years. While slowdown of export (3-month smoothened) growth rate was larger in China than in the world in Jun.- Sep. 2011; the substantial fall of global exports dynamics towards negative territory in Jun.-Oct has led to an increasing gap with China exports growth rate which has prolonged until Jan Consequently, the share of China s exports in global exports has progressively risen above 12% in 2012Q3 and Q4. Even though China s imports dynamics has been more volatile in recent quarters, it has almost permanently remained above the global trend (except in seasonal drop in China in Jan. 2012). Therefore, the share China s imports have also increased to 10% of global imports towards the end of China and World Trade Dynamics since 2011 Share of China in World Trade in 2010 The higher exports growth rate than import growth rate registered both in monthly basis (except in February and July) and annual basis in 2012 has led to a substantial trade surplus accumulation. Annual trade surplus has increased by +50% in 2012 to USD 231 bn, but remained below the record surpluses registered in 2007 and After a quasi-null trade surplus in 2012Q1, monthly trade surplus has averaged above USD 25 bn per month between April and December However, in spite of a much lower seasonal trade deficit recorded in March 2013 (USD -0.8 bn against USD -32 bn in Feb. 2012), the average trade surplus has declined to USD 16 bn per month over the five first months of Furthermore, the recent reduction in difference between exports and imports growth rates, as suggested by the meeting of the two smoothened trade dynamics, should reduce trade surplus accumulation. Indeed, the long-term performance of the trade surplus (12-month rolling trade balance accumulation to limit seasonality effects) has stabilized at a new peak of almost USD 280 bn in the last months, a level only achieved during the global financial crisis (Nov Jul. 2009). A report written by TAC - Applied Economic & Financial Research 25

30 China s Monthly Trade Balance since June 2011 China s 12-months rolling Trade Balance since 2003 The analysis of trade performances on quarterly basis allows reducing the seasonal effect of Chinese New Year. The latest quarterly figures show a significant decline in absolute terms between 2012Q4 and 2013Q1 for both exports and imports, but the dynamics on annual basis has indeed accelerated. Exports growth rate reached has even accelerated in the last two quarters to an impressive +18.4% y/y in 2013Q1 (against +7.7% y/y in 2012Q1); in parallel, imports growth rate has rebounded from +1.4% y/y in 2012Q3 to 8.3% y/y in 2013Q1. This recent dynamics confirms the trend reversal observed in 2012Q4, with an expanding gap between exports and imports growth rates; in turn, the trade surplus registered in 2013Q1 (i.e. USD 43.5 bn) is the largest firstquarter trade surplus in four years. China s Quarterly Trade Performances since 2011Q3 Exports Imports Trade balance USD bn y/y change USD bn y/y change USD bn 2011Q % % Q % % Q % % Q % % Q % % Q % % Q % % 43.5 Sources: CCS, TAC Development in China s trade policy and diplomacy Nowadays, apparent signals of trade protectionism may contradict with the current trade policy choice. In spite of increasing relations between some of the largest trading partners globally (US, EU, Japan and China), cases of tensions and disputes can be detrimental to sound diplomatic and industrial developments. Government protectionist measures have been rising, prominently to support domestic firms at the expense of trading partners companies. Recent reporting 1 indicates that China has adopted more than 150 measures since November 2008, including half almost certainly harming foreign commercial interests. In fact, trade defence measures (Anti Dumping and Countervailing Duties, safeguards) have recently been imposed on toluidine imported from the EU, on dispersion unshifted single-mode optical fiber from South Korea, on paper for electrolytic capacitor from Japan, or on pyridine from India and Japan. 1 Global Trade Alert, Protectionism's Quiet Return: GTA's Pre-G8 Summit Report, June 2013, Centre for Economic Policy Research. A report written by TAC - Applied Economic & Financial Research 26

31 Several cases of China-EU trade frictions have emerged in recent months, especially in high-profile sectors like telecom equipment, steel, solar panels. Even though no formal legal proceedings have yet begun to investigate potential violation of the antidumping and subsidies laws of the EU by Chinese electronic equipment makers; the European Commission has initiated investigations on solar panels (and their key components), as well as on solar glasses. These products are imported from China in the EU at prices below market value thanks to alleged financial subsidies granted by China s government. In parallel, Japan has lodged a complaint with the World Trade Organization (WTO) in December 2012 against China s anti-dumping duties on high-performance stainless steel seamless tubes ( HP-SSST ); since duties are also affecting other international and Europeans companies; the EU, India, Korea, Russia, and the US have reserved their third party rights to be heard and to make written submissions to the panel adjudicating the dispute. On June 13, the EU notified the WTO of a request for consultations with China on the latter s antidumping duties on certain HP-SSST from the EU. However, the magnitude and significance of bilateral relations between large trade partners have implied cooperative and positive developments in terms of market access and competitiveness improvement. The EC Trade and Investment Barriers Report 2013 indicates areas with progress achieved in 2012 with China. For example, China has announced the removal of exports duties and quotas on raw materials after EU and US actions; this will support companies in Europe to gain access to Chinese raw materials. Some progress was also achieved on the indigenous innovation policy, on standardisation and technical regulation, and export financing conditions and subsidies. The political transition in China has not altered the strategic ongoing strengthening of economic relations with partner countries. After Mr. Gao Hucheng took office as Minister of Commerce in March 2013, he has met several trade officials from trade partners (Russia, Finland, Uzbekistan, Thailand, Canada, Kyrgyzstan, Vietnam, Singapore, Korea, Hong Kong, Kazakhstan, and the Netherlands) and multilateral institutions (WTO, APEC). At the regional level, negotiations for a trilateral China-Korea-Japan Free Trade Agreement have been launched in November 2012; the first round of negotiations took place in Seoul in March 2013, and the second and third rounds of negotiations will take place in 2013 in China and Japan respectively. The comprehensive institutional framework can effectively promote trade and investment among the three countries, and support further economic integration in Asia. The spread on Asian FTAs (from 3 in January 2000 to 76 in April 2013) has in fact benefited from largest economies involvement in regional trade policy (China, Japan, India and ASEAN). However, the trend in trade integration has been ambiguous with increasing number of bilateral trade agreements between Asian (and beyond) countries, and the growing complexity of bilateral/multilateral trade and financial agreements (so called noodle-bowl ). Centricity of ASEAN-based project for a regional comprehensive economic partnership (ASEAN + China, Japan, Korea, India, Australia and New Zealand) may face potential clash from alternative regional consolidation (Trans-Pacific Strategic Economic Partnership - TPP with already 12 countries); the future dynamic of regional integration will definitely rely on the diplomatic/conceptual approach of China s leadership for talking regional consolidation challenges Exploring discrepancies in trade data Differences in bilateral trade data have been historically significant; the discrepancies arise from conceptual and methodological differences in collecting and processing the data. Although China and partner countries follow the same international guidelines for statistical territory definitions; the timing of recording, the inclusion of re-exports in exports statistics and the attribution of imports to country of origin and exports to country of last known destination are key sources of discrepancy. Indeed, indirect trade to an intermediate country (mostly Hong Kong) may imply that the last known destination is not available by the exporters, while the importers will report the actual Country of Origin. A report written by TAC - Applied Economic & Financial Research 27

32 Exports to China reported by the US Census Bureau are on average 18% lower since January 2004 than Imports from US reported by China Customs Statistics; however, the dynamics in US-China bilateral trade data discrepancy has resumed since early Gap in official data between US and China and long-term trend since 2004 On the opposite, US Imports from China reported by the US Census Bureau are 37% higher than the China s Exports to US! But the gap in bilateral trade data according to the two national sources has gradually reduced, from 50% in the mid-2000s to about 20% in Jan.-Apr. 2013, while bilateral trade has continued to grow. For EU-China bilateral trade, the gap between official data of exports and imports has converged significantly in the last years. While the gap between CCS figures for China s Imports from EU and Eurostat s figures of EU Exports to China remained roughly stable at an average of 13% since Jan. 2007, despite large monthly volatility; the gap between China s Exports to EU reported by CCS and EU Imports from China reported by Eurostat has declined from more than 30% on average in 2007 to 14% on average in Gap in official data between EU and China and long-term trend since 2007 In recent months, the pick-up in China trade dynamics became apparently distorted, especially when compared to trade partners official trade data statistics. Indeed, the gap between US and China official data for westbound trade (US to China) has reached all-time highs in March and April 2013 (US exports to China at USD 18 bn according to US Census Bureau, against USD 29 bn according to CCS for the two months). Moreover, respective bilateral trade data from Taiwan and Hong Kong are substantially different from CCS data for exports and imports. While Hong Kong (Census and Statistics Department - HKCSD) and China Customs Statistics have published almost comparable bilateral trade data between 2007 and mid-2010, the gap for China-to-Hong Kong trade has rapidly expanded (17% on average per month in 2011; 25% in 2012; and 46% in the first four months of 2013). Chinese exports to Hong Kong have cumulated at USD 145 bn in Jan.-Apr according to CCS, and at only USD 77 bn according to HKCSD. The surge in exports was particularly strong in China s exports to Hong Kong, up 69% y/y in the first four months of 2013 according to CCS; but data from HKCSD indicates that Hong Kong imports from mainland China rose more moderately by 11% y/y over the same period. A report written by TAC - Applied Economic & Financial Research 28

33 Partners countries Exports to China in 2013 Partners countries Imports from China in 2013 In parallel, the difference between the Eurostat and CCS data for bilateral trade has been more consistent over the last two quarters. CCS data for EU exports to China were 12% and 7% higher than Eurostat data for 2012Q4 and 2013Q1 respectively; and Eurostat data for EU imports from China were 13% higher in 2012Q4 and 18% in 2013Q1 than CCS data. Similarly, the trade discrepancies between Japan and China official sources have remained endurable in 2013Q1 when compared to 2012Q4, although it is historically larger in magnitude (above 20% gap on average between 2007 and Apr. 2013). In CCS database, China import commodities made in China! There are the following two causes: (1) Some commodities are exported to Hong Kong, Taiwan or other countries, finally these commodities are re-sold to China s importers. Then China imports the commodities which are originally made in China. (2) There are many foreign invested factories in China s bonded area to produce electronic goods. When these commodities are sold to China s companies outside of the bonded areas. China imports the commodities which are originally made in China. China Imports from China The bonded trade areas are purposely developed to facilitate exports; manufacturers can imports goods from China s and foreign countries for final processing in the bonded zones (free trade zones, export processing zones, bonded logistics parks, bonded ports, and comprehensive bonded zones). With minimum bureaucracy and rapid logisitic, goods can be imported to bonded trade area, generally duty-free and with tax rebates from the Chinese government for the exporters, and re-exported to China, sometimes in one day. Companies may use their exported goods to bonded trade areas as collateral to obtain Letter of Guarantee (LoG) from Chinese banks; with LoG, companies can obtain foreign currency loans in offshore banks (typically Hong Kong), which are converted in RMB to be deposited in Chinese financial system. The spread on deposit interest rates and the appreciation trend of the RMB have allowed trading companies to register gains from higher return on financial products and carry trade gains. In addition, repeated one-day shipments and over invoicing of products can circumvent China s tough capital control and create an attractive leverage effect for Chinese banks and unscrupulous trading companies. Investigations by SAFE on mismatched trade invoicing and doubtful round-tripping of goods in bonded trade areas combined with tightened rules on capital inflows are now on going to curb illegitimate transactions and realign China s trade data with real domestic and international economic development. A report written by TAC - Applied Economic & Financial Research 29

34 Overall, these practices and consequent inflation in trade figures, especially exports from China reported by CCS, have likely significantly overstated exports figures. Shipping volumes as reported by shipping companies and trading logistics companies have been flat; this is also confirmed by the leading indicators (PMI export order index data). Potential adverse implications include China s financial system soundness (quality of bank lending and wealth management products), on exchange rate regime, due to less effective management of cross border short-term capital flows by domestic companies; as well as regional and national GDP growth accounting. China PMI Manufacturing - New Export Orders Index 3.2 Analysis of China s trade partners and products Diversification of trade flows This section presents the usual systematic analysis China s trade performances by partner and country/region. The analysis is based on data provided by China s Custom Statistics, and aims at identifying key geographic patterns in China s trade performances. The approach focuses on trade dynamics measured on the last cumulated 12 months (May 2012 to April 2013). The below table summarizes the fastest and slowest growing markets for China on the left side, and the fastest and slowest growing suppliers on the right side. Overall, the latest cumulated 12-month growth rate for China s total exports slowed down to +11.2% on an annual basis, when compared to May 2011-Apr (against +14.1% the previous year) while China s imports growth rate decelerated sharply to +6.0% (against +16.5% in May 2011-Apr. 2012). The geographical patterns of China s exports and imports dynamics confirm the significant rise in several Asian and commodity producing countries as major markets and suppliers. - China registered remarkable growth rates of exports during the last 12 months to several commodity exporters (at the noticeable exception of Iran which is facing sanctions on international transactions). Though China s exports to Oman have almost doubled over the period of interest, they remained at only 10% approximately of imports from Oman. - Similarly, China s exports to ASEAN countries and Hong Kong have accelerated to strong level; while China s demand has been less impressive from these Asian countries. On the opposite, Japan and India registered a decline in trade over latest 12 months on annual basis. - The decline in both exports to the EU 27 (-5.9% y/y) and imports from the EU 27 (+1.3% y/y over the same period) reflects mediocre economic conditions in the EU, compressing demand for China s products. Further, several EU Member States (e.g. Italy, Belgium, France, Germany, Spain...) appear among the slowest markets, with absolute decline in demand and supply over the last 12 months. Switzerland registered startling opposite dynamics in recent exports and imports; China s soaring demand for physical gold has led to exceptional imports in March 2013 (USD 7.3 bn). A report written by TAC - Applied Economic & Financial Research 30

35 The fastest and slowest growing markets and suppliers (cumulated 12-month growth rate: May 2011-Apr May 2012-Apr. 2013) Combining this analysis with the similar previous exercises, the list of regular fastest growing suppliers confirm the intensification of trade relations with South Africa, Oman, Vietnam and the U.A.E., while Venezuela is exiting the list of countries identified in the last three consecutive issues of the EU-China Economic Observatory. In parallel, only Saudi Arabia has remained regularly among the fastest growing markets; Angola has also substantially intensified its imports from China in recent years. On the contrary, five European economies are identified among the slowest growing markets; while Japan and India are persistently among the slowest growing suppliers. A report written by TAC - Applied Economic & Financial Research 31

36 Countries identified in the past 3 issues of Observatory The share of Asian countries (excluding Japan) in China s exports has greatly improved over the last year, climbing from 37.9% in 2011Q3 up to 46.5% of all exports in 2013Q1, representing a 20% increase in Asian demand for Chinese goods between the two quarters. Except for Africa, the shares of all other regions have declined in recent quarters, more significantly for EU and North America. However, in spite of the apparent concentration of exports to Asian markets, a relative diversification is progressively taking place among Middle East and south Asian countries. Similarly, Asian, African, as well as North America s products increased their share in Chinese imports basket; Asian countries represent now more than 50% of products sourcing for China in 2013Q1. Japan is in fact facing the largest receding in share of China s imports since 2011; as evidenced by the 38% y/y decline in Chinese imports of Transport vehicles (HS2 Section 87) from Japan in 2013Q1. China s Exports per region since 2010 China s Imports per region since 2010 A report written by TAC - Applied Economic & Financial Research 32

37 3.2.2 US and EU compared Looking first at imports from China in total imports, we notice that the in relative weight of China in total imports between the EU and the US is almost insignificant between the two regions. Weight of China in EU and US Imports Moreover, the share of China had almost constantly increased between 1999 and 2010, but then has registered a similar decline with both trade partners (even if slightly more marked in the case of EU). In fact, US imports from China reached USD 426 bn in 2012 (+6.6% y/y). Also, considering that volumes of Chinese exports to US and EU are relatively similar (USD 352 bn and USD 334 bn in 2012 respectively, according to CCS), this suggests a similar integration of China on the European and US markets. The recent performances of Chinese exports to EU and US confirm the overall slowdown of demand from both partners. The trade dynamics show the strongest decline of China s exports to EU: after a persistent decline of monthly exports on annual basis in 2012, the brief rebound in Dec Feb was followed by a resuming of negative dynamics (-10% y/y in May 2013). China s Exports to EU and US In parallel, China s exports to US have maintained positive growth between March 2011 and October 2012; then similarly to EU, exports registered decline in dynamics in last three months (-2% y/y in May 2013). A report written by TAC - Applied Economic & Financial Research 33

38 Turning to China s imports from EU and US, we adjust for Mineral Products, as they are less relevant traded goods bilaterally. Weight of EU and US in China s Imports (excluding Mineral Products) The EU has a larger share on Chinese market, suggesting a more advanced level of penetration. However, the share of China s imports from EU has moderated in recent months. On the opposite, the US has gained relative weight on Chinese market. In terms of recent imports dynamics, imports from EU and US into China have a highly similar trajectory. However, while China s imports from EU has grown consistently at a higher pace than China s imports from US between March 2011 and March 2012; the relative gap in imports dynamics has completely reversed between US and EU since April Indeed, the declining Chinese imports from EU (-2.3% y/y in Jun May. 2013) has favoured the convergence of relative share of EU and US (+12.5% y/y over the same period) in total China s import. When comparing bilateral trade balances of China with US and EU, the structural trade surplus with US has increased in 2012 and the last two months of 2013; in comparison the EU-China trade balance has significantly declined since Therefore this suggests that the relative contribution of US-China trade balance in total Chinese trade surplus is growing. A report written by TAC - Applied Economic & Financial Research 34

39 China s bilateral Trade Balance with EU and US and Total Trade Balance Evolution by products We provide here a synthetic assessment on trade developments in China by products, based on China s Custom Statistics report of 97 products for the level-2 HS classification. The structural evolution of key export and import products is emphasized by recent robust cyclical dynamics; while the concentration of exports is in fact accelerating in The two major Chinese exports have reported ambivalent dynamics with a major acceleration of exports of Electrical machinery and equipment (HS Code 85) and slight slowdown in machinery and mechanical appliances exports (HS Code 84). Nevertheless, the share of these two products in total exports performances of China has continued to slightly increase: 44.4% of total exports in Jan.-Apr (USD 309 bn) after 42.1% in 2012 (USD 255 bn in Jan.-Apr. 2012). After a rise of 9.3% y/y in 2012, exports of Electrical machinery and equipment boomed by +34% y/y in Jan.-Apr. 2013, representing an impressive average of almost USD 50 bn per month over the last four months. Also, exports of pearls and stones (HS Code 71) continued their considerable expansion since 2010Q4, from +65% y/y in 2012 to +82% y/y in In parallel, only two products have registered significant decline in 2013: (1) exports of Ships and boats (HS Code 89) continued their -10% y/y decline in 2012 with a major fall of -30% y/y in Jan.-Apr. 2013; (2) exports of Toys, games and sports requisites (HS Code 95) have declined over the last seven months on annual basis, but the seasonality of volumes of exports has a major impact on its dynamics. A report written by TAC - Applied Economic & Financial Research 35

40 Dynamics and share of main China s exports Product exports above USD 6.5 bn in Jan.-Apr (or 1% of total exports) Products 2012Q2 2012Q3 2012Q4 Jan.-Apr % 85 Electrical machinery and equipment and parts thereof 7.8% 7.4% 15.1% 33.5% 26.9% 84 Nuclear reactors, boilers, machinery and mechanical appliances 11.5% -3.4% 6.2% 5.8% 17.5% 61 Articles of apparel and clothing accessories, knitted or crocheted 5.0% 2.3% 20.8% 29.7% 3.9% 94 Furniture 46.4% 38.1% 27.1% 29.5% 3.7% 90 Optical, photographic, instruments and apparatus 21.2% 26.2% 19.7% 20.4% 3.5% 71 Natural or cultured pearls, precious or semi-precious stones 64.3% 108.2% 58.5% 82.1% 3.3% 39 Plastics and articles thereof 25.0% 25.6% 19.1% 22.7% 2.7% 62 Articles of apparel and clothing accessories, not knitted or crocheted -6.6% -5.8% 3.2% 8.8% 2.6% 73 Articles of iron or steel 19.7% 8.3% -2.1% 7.0% 2.6% 87 Vehicles other than railway or tramway rolling-stock, and parts and accessories thereof 19.1% 7.0% 3.4% 8.4% 2.6% 64 Footwear, gaiters and the like 15.8% 9.3% 20.5% 20.5% 2.1% 29 Organic chemicals 2.3% -1.0% 7.6% 5.1% 2.0% 27 Mineral fuels, mineral oils and products of their distillation -11.0% -13.9% 6.2% 12.3% 1.9% 72 Iron and steel -9.1% -18.1% -2.7% 6.1% 1.8% 89 Ships, boats and floating structures 0.9% -19.7% -23.2% -29.8% 1.3% 42 Articles of leather 18.2% -3.2% 6.2% 26.8% 1.3% 95 Toys, games and sports requisites 10.0% 5.5% -3.2% -12.3% 1.2% 63 Other made up textile articles 8.6% 1.2% 6.0% 10.1% 1.1% 40 Rubber and articles thereof 14.4% -3.9% -3.0% 1.2% 1.0% Sources : CCS, TAC Even though, imports of Mineral fuels (HS Code 27) have declined by -1.1% y/y in first four months of 2013; they remain the largest component in China s import basket (USD 452 bn in 2012) mainly due to a large increase of Crude petroleum oil imports (+6.8% y/y on volume basis in 2012). Conversely, imports of Electrical machinery and equipment (HS Code 85) have substantially accelerated in 2013, from +16.1% y/y in 2012Q4 to +42.6% y/y in Jan.-Apr In parallel, their share on total Chinese imports have raised to 22% in 2013, a similar level achieved by imports of Mineral fuels. Among the major imported products by China, four different have registered lengthening periods of declining imports dynamics - Machinery and mechanical appliances (HS Code 84), Vehicles, parts and accessories (HS 87), Copper (HS 74) and Iron and steel (HS 72) - testifying a slowdown in capital goods and commodities demand. Noticeably, the miscellaneous category is substantially expanding (from +39% y/y in 2012 to +86% in Jan.-Apr. 2013), suggesting a potential compensating effect in decline in Copper and Iron. A report written by TAC - Applied Economic & Financial Research 36

41 Dynamics and share of main China s imports Product imports above USD 7.0 bn in Jan.-Apr (or 1% of total imports) Products 2012Q2 2012Q3 2012Q4 Jan.-Apr % 27 Mineral fuels, mineral oils and products of their distillation 10.7% -9.3% 0.3% -1.1% 22.6% 85 Electrical machinery and equipment and parts thereof 1.6% 14.0% 16.1% 42.6% 22.2% 84 Nuclear reactors, boilers, machinery and mechanical appliances -12.3% -9.0% -5.1% -9.2% 7.7% 26 Ores, slag and ash -3.2% -19.3% -16.0% 5.0% 6.9% 98 Commodities not classified according to kind 94.9% 61.4% 24.6% 85.7% 5.6% 90 Optical, photographic, instruments and apparatus 1.8% 12.5% 14.8% 16.2% 5.2% 29 Organic chemicals -1.2% -10.6% -8.2% 7.2% 3.3% 39 Plastics and articles thereof -1.5% 1.0% 1.7% 2.1% 3.2% 87 Vehicles other than railway or tramway rolling-stock, and parts and accessories thereof 29.1% 6.7% -18.2% -14.9% 3.0% 74 Copper and articles thereof 11.5% -8.3% -17.9% -20.7% 2.2% 12 Oil seeds and oleaginous fruits 27.9% 19.2% 17.3% 2.3% 1.6% 72 Iron and steel -14.6% -18.9% -25.0% -10.0% 1.1% 40 Rubber and articles thereof 0.5% -12.3% -16.3% 6.6% 1.0% Sources : CCS, TAC Focusing on the dynamics of main traded products of China, the large trade deficit for mineral fuels has gradually expanded between January 2009 (USD 7.7 bn) and May 2012 (USD 39.9 bn); but the deterioration of trade deficit has stopped over the last year. Similarly, the trade surplus of Machinery and mechanical appliances (HS Code 84) and Electrical machinery and equipment (HS Code 85) has progressively increased since 2009, but at a slower pace. Furthermore, the accumulation trend for these products trade surplus has slowed down in recent months: increase of +21% y/y and +5% y/y in Jan.-Apr for Machinery and mechanical appliances and Electrical machinery and equipment respectively, against +26% y/y and +12% in China s Trade Balance of main traded products A report written by TAC - Applied Economic & Financial Research 37

42 3.3 EU-China trade developments In this section of the EU-China Economic Observatory, we provide a synthetic review of the recent bilateral trade relations between the EU 2 and China, based on Eurostat statistics Overview After positive dynamics in 2010 and 2011, the total EU-China bilateral trade has continued to expand in 2012 and early 2013, but at a decelerating trend. In fact, after +20% in 2011, EU Exports to China only increased by +5.5% on annual basis in 2012 (to reach EUR 144 bn), while EU Imports from China declined by -1.3% on an annual basis (to EUR 290 bn, +4% in 2011). However, despite this slowdown in EU exports to China, the bilateral trade deficit reduced again in 2012, with EUR 95 bn. Overview of bilateral trade between the EU and China EUR bn EU Exports to China EU Imports from China EU-China Trade Balance Sources: Eurostat, TAC EU-China Annual Trade Balance since 2005 The following graph clearly shows how both exports and imports have registered staggering slowdown in growth rates since The EU-China trade dynamics have been increasingly fading from the high growth levels registered early 2011 (in the range +30% / +40% y/y), to negative growth rates at the end of 2012 and early 2013 (for both exports and imports). But if in 2011 and early 2012 the decelerating trend was faster for EU Imports from China than for EU Exports to China, it is obvious that they now tend to converge. In fact, if monthly growth rates of exports growth remained positive until mid-2012, they substantially declined to turn negative in September 2012, for the first time since April 2009; the dynamics of imports being more volatile 22 Except otherwise specified, all computations for the EU are based on 27 member states. 3 The latest data available at the moment of computation were for March A report written by TAC - Applied Economic & Financial Research 38

43 and mediocre since mid As a consequence, both of these decreasing trends have now almost stabilized, and lie in the range -10% / 0% (y/y) since 2012 Q3, testifying the deteriorated economic conditions in the EU and China. EU-China Monthly Bilateral Trade Dynamics since 2011 But if EU imports have almost stabilized since May 2011 and while EU exports to China continued to grow in 2011 and early 2012, how can the negative trend on the trade deficit be so limited? The difference in magnitude between imports and exports performances is a key element to understand this. In fact, with a magnitude of import that is twice as much as exports, it would require a massive and persistent gap between respective growth rates to reduce more significantly the trade deficit. The trade deficit reduced however significantly since 2011, from EUR 43.9 bn in 2011Q3 to EUR 33.6 bn in 2013Q1. EU-China Quarterly Exports and Imports since 2011Q3 EU Imports from China EU Exports to China Trade Balance EUR bn yoy change EUR bn yoy change EUR bn 2011Q % % Q % % Q % % Q % % Q % % Q % % Q % % Q % % Q % % Sources: Eurostat, TAC A report written by TAC - Applied Economic & Financial Research 39

44 3.3.2 Trade Performances of EU Member States In terms of EU Member States trade performances, the new figures confirm the patterns already identified in the previous issues of the EU China Economic Observatory. In fact, EU Exports to China remain substantially concentrated on Germany (with EUR 61 bn in 2012) and these figures are confirmed in 2013 Q1, with 46% of EU MS total exports to China originating from Germany, other countries, except France, accounting for less than 10%. With only 21% of import from China going in Germany, the degree of concentration is clearly less important on the import side. In fact, if Germany remains the largest importer in 2013Q1, it is closely followed by The Netherlands (19%) and UK (14%). In terms of bilateral trade balance, Germany and Finland registered the only positive bilateral trade balance among EU Member States, with a trade surplus of EUR 1.1 bn in 2012 for Germany, and EUR 0.2 bn for Finland. But the graph below also shows that two MS mostly benefited (or contributed) to a large part of the decrease of the trade deficit with China, namely The Netherlands and UK, while the deficit of Italy with China clearly increased in 2013 Q1 compared to 2012 Q4 (+37%). EU-China Bilateral Trade Balance by EU Member States A report written by TAC - Applied Economic & Financial Research 40

45 4 Foreign investment In this section of the report, we continue our regular monitoring of the inward and outward investments of China. We start by providing a comparison of various sources of FDI statistic in China, attempting to explain differences along with key messages from the mix of all FDI statistics. The second section focuses on the recent on the most recent FDI performances (by partner, by sector) and the chapter ends with a focus on transit countries to invest in and out of China. Key Elements Various sources record FDI in and out of China, and their methodology widely varies, providing a muddled picture about FDI in China. Based on an in-depth research, the main explanations of such differences can be explained by either additional components in FDI statistics (ex: China classifies in BOPS statistics imported equipment as FDI and include a substantial amount of round tripping), or important gaps between some component such as the recording of reinvestments of earnings. Despite huge gap between FDI statistics, several key messages can be drawn: (1) the catch-up of ODI over FDI in China over the recent years, (2) the increase in reinvestment of earnings in China while the equity and investment fund shares (i.e. the real new FDI ) modestly decreased since the Global Financial Crisis. (3) This increase in reinvestment of earnings is explained by a combination of two main reasons: serving the domestic market in a context of market access difficulties, implying that foreign investors try to increase market share in China through their local affiliates. COFM figures for 2013Q1 confirm the rebound in global FDI inflows and outflows observed since 2012Q3. However, this increase is mostly concentrated on a small number of very large deals (this is again true for both inflows and outflows). MOFCOM figures suggest that Hong Kong is by far the main FDI partner of China but the statistics lack of transparency (including important round-tripping effect etc). Focusing on real new FDI, COFM figures draw a very different picture than MOFCOM. The figures show that foreign countries generally invest in China without transiting by another country. But the phenomenon tends to decline over the recent years, compensated by an increase in investments through local affiliates (20% of the number of operations in 2012). Hong Kong serves as transit for less than 3% of foreign operations in China, while the share of China FDI abroad transiting by Hong Kong increased to 6%-8% over the period In general, similar strategies are used by investors into and out of China with a significant part of deals operated through their subsidiary in the biotechnology, the real estate, the energy and food & beverages. Conversely, companies choose to directly invest (from the ultimate parent) in the electronic/software/it, the chemicals, the healthcare and services, assuming easier access in such markets. A report written by TAC - Applied Economic & Financial Research 41

46 4.1 Full light on the cloud of FDI statistics In the background of the economic slowdown in China, FDI statistics in China are often used by analysts to reflect the global confidence in the Chinese economy. However, various Chinese and international sources record FDI in and out of China, and their methodology varies. Statistics are based on different computation methods, either balance of payments or FDI approval process, and different definitions (components of FDI). Such differences can provide a muddled picture about FDI in China by sometimes resulting in opposite conclusion about FDI trend. Moreover, understanding concept differences behind Chinese official sources is a complex task due to the lack of transparent and clear definition. This section attempts to disentangle the complex compilation of FDI statistics in China. To do it, an in-depth research is provided, including a comparison of official FDI statistics on China and reviewing the different methodologies. The main objective is here to clarify key concepts and more importantly, to provide key messages and common findings from all statistics about the recent FDI trend in China FDI statistics: a question of concept The main official sources for data on Chinese FDI are compiled by the Chinese Ministry of Commerce (MOFCOM) and the State Administration of Foreign Exchange (SAFE). In addition, statistics from international institutions are also usually used to analyse Chinese FDI such as the IMF (with the Balance of Payment Statistics, IMF/BOPS) and UNCTAD. Overall, statistics on direct investment include cross-border investments made with the objective of establishing a lasting interest to exercise an influence in the management of the direct investment (the target entity) which is evidenced by the ownership of at least 10% of the voting power by the direct investor. While the quality of China s data on cross-border investment has improved significantly over the past decade, TAC has developed for EC officials (for DG Trade since 2010) a web-platform, ChinaObs fdimonitor (COFM) aiming at providing more detailed and timely information on China investment flows. Looking at the historical path, the huge differences between sources are directly explained by the concepts. Indeed, we can breakdown official statistics into three groups: (i) SAFE and IMF/BOPS are based on Balance of Payment statistics through assets/liabilities concepts, covering recorded money transfers (ii) MOFCOM and UNCTAD statistics are based on registration and investment approvals (compiled on data on information collected by departmental commercial bureau) (iii) COFM data is based on news from authoritative sources (Thomson Reuters for information on Merger and Acquisitions and a mix of an own proprietary tool and information from fdimarkets-financial Times Group for the Greenfield investments). Such differences can provide very different messages. Indeed, while FDI outflows from China published by SAFE, IMF/BOPS and TAC/COFM show a rapid increase until 2008, such sources reveal a sudden stop in the ODI dynamic from 2008 in the background of the Global Financial Crisis. Conversely, MOFCOM, UNCTAD and TAC/COFM show a continuous positive trend on outflows FDI from China with no apparent effect from the GFC. The FDI differences are more noticeable on inflows than outflows. In fact, while MOFCOM, UNCTAD and COFM data are rather on a similar path until 2009, divergences appear over the past three years with a decline in TAC/COFM data in 2010 while MOFCOM and UNCTAD data continue to show an increase in FDI inflows. Conversely, IMF/BOPS and SAFE data draw a very different picture with a very large increase in 2010 and amount are more than twice MOFCOM figures (and more than four times COFM data). A report written by TAC - Applied Economic & Financial Research 42

47 FDI inflows into China by source (USD bn) FDI outflows from China by source (USD bn) Understanding the differences behind these statistics is a challenging task which, to our knowledge, has not been already clearly explained in the past analyzes but rather suggest some hypothetic ideas. We have therefore undertaken an in-depth research in order to provide some clarification. Underlying concepts help understanding some differences: - For instance, looking at FDI outflows from China, MOFCOM figures, reflecting government-approved investment project, provides more optimistic views than balance of payments series that integrate actual money transfers. FDI inflows data show opposite view with amount relying on approved projects much lower than financial flows. - But the definition itself can also explain differences. In fact, the IMF definition of FDI includes 12 different components: equity capital, reinvested earnings of foreign companies, inter-company debt transactions, short- and long-term loans, financial leasing, trade credits, grants, bonds, non-cash acquisition of equity, investment made by foreign venture capital investors, earnings data of indirectly-held FDI enterprises, control premium and non-competition fee. MOFCOM definition is more ambiguous, lacking of clear definition (at least in English version). Based on academic research and interviews with experts, we explored two possibilities: either SAFE includes additional components in their statistics or the SAFE, the MOFCOM and COFM find divergent figures. Overall, three explanations can be found in the literature. - Bajpai and Dasgupta (2004) analyzed FDI into China and India and found that imported equipment were classified as FDI in BOP statistics, and could partly explain these discrepancies in statistics. In fact, Chinese Customs statistics specifically details imports of equipment materials invested by Foreign Invested Enterprises (FIE). This component can explain in part the divergences, but mainly between 2005 and Indeed, imports of equipment materials has been divided by two since A report written by TAC - Applied Economic & Financial Research 43

48 China imports - Equipment materials invested by FIE (USD bn) - Then, as mention in the OECD world paper on China Investment Policy (written by Ken Davies, 2013), Hong Kong has been the largest single FDI source (according to MOFCOM figures) since the country opened to foreign investment in the late 1970s. While there are some large investors based in Hong Kong, there is undoubtedly a high proportion of capital routed through Hong Kong from other parts of the world, as well as continued round-tripping of Chinese investment. However, it remains really complex to compute exactly the share of this round-tripping effect. For example, the World Bank and other agencies have estimated that the scale of this round tripping could be as high as a quarter of the total FDI inflows into China (see World Bank, 2002). However, it represents old computation and they did not provide clear definition on round tripping FDI and did not explain its estimation method. - But the main explanation of such differences relies on the recording of reinvested earnings. Some analysts argue that the difference between SAFE and MOFCOM figures are explained by the introduction of reinvested earnings only in SAFE figures, but our investigations show that it is not completely true and that the MOFCOM also include approved reinvested earnings in their figures. In fact, the MOFCOM provides two types of information on FDIs. The first one is related to the number of operations called newly approved foreign invested enterprises, which suggest that the capital might still in the hand of foreign investor and not in China yet. But the second component, the actual use of foreign investment, refers to the amount of capital that has been actually invested in China. To our understanding, it includes both the capital that was stated in the contract and reinvested earnings. We find however that SAFE registers much more reinvested earnings that MOFCOM. Our assumption is that they are taking into account all profits already registered in state or departmental administration of Industry and Commerce of China, and even if profits are not yet already reinvested and/or approved by MOFCOM. The inherent difficulty in accounting for earnings of foreign companies operating in China was under the main source of the recent SAFE revision of the Balance on Payments statistics (from April 2013). Income earned by foreign enterprises in China includes both repatriated profits earned by foreign companies and transferred out of China, and retained earnings of foreign companies kept in China. Peterson Institute for International Economics (PIIE) recently studied this recent SAFE current account balance revision. They argue that, although capital controls make it relatively easy for SAFE to debit repatriated profits as investment income in the current account and foreign direct investment in the capital account, those foreign-earned profits kept in the country are more difficult to track. MOFCOM do not publish details on the share of reinvestment of earnings in FDI inflows into China. However, they provide information on outflows FDI from China. As shown on the next table, the comparison on reinvestments of earnings by source clearly show that SAFE registers only around 50%- 60% of MOFCOM figures which mostly explain the total difference between both sources. A report written by TAC - Applied Economic & Financial Research 44

49 ODI - Reinvestment of earnings by main source To sum up the analysis and help the reader understanding the main differences between sources, we attempt to recompile FDI inflows by taking into account all components explained above on the graph below: imported equipment, round tripping effect (approximated as 25% total FDI computed both MOFCOM and IMF figures) and finally reinvested earnings. Decomposition of FDI inflows into China by components in Key messages from the mix of Chinese FDI statistics While FDI statistics are based on different concepts and compilation, this section aims at summarizing key messages and common trends from all sources. - Catch-up of FDI outflows from China over inflows. Indeed, MOFCOM and COFM figures show a rapid increase of the ODI compared to FDI in China, close to 60% looking at MOFCOM figures and close to 100% (except in 2009) according to our data, meaning that outflows would have already reached the A report written by TAC - Applied Economic & Financial Research 45

50 same level than FDI inflows into China. Looking at the IMF/BOPS, FDI index is different, decreasing over 2010 and However, if we only retain the equity and investment fund shares, the index also reveal an increase in 2010 and 2011, close to 40%. - Increasing differences between SAFE, MOFCOM and COFM suggest an increase in reinvested earnings since the beginning of the Global Financial Crisis. The breakdown of the IMF Balance of Payments confirms such increase in reinvestment of earnings, accounting for 44% of total FDI inflows over the period while it only equalled 11% in 2007 and Looking at the real new FDI into China from IMF/BOPS figures, the share of equity and investment fund shares show a dynamic that is similar to COFM data, resulting in a modest slowdown since Indeed, the IMF/BOPS equity and investment fund share show a 4% decrease between 2007 and 2012 while COFM deeper decline at 18%. In parallel, both sources reveal a strong increase in FDI outflows from China over the recent few years. Breakdown of FDI inflows into China Breakdown of FDI outflows from China - The increase in reinvested earnings reflects the enforcement of regulation as Chinese authorities clearly define priorities in their FDI catalogue. As described in the 2013 European Business Confidence in China (published by ECCC and Ronald Berger Strategy Consultants), the top regulatory obstacle for doing business in China is the market access difficulties. However, more respondent that ever before said the primary reason for being in China is to serve the domestic market. The equivalent US survey, the 2013 China Business Climate Survey Report (published by the American Chamber of Commerce in the People s Republic of China) confirmed that an important change revealed in this survey was that relatively fewer respondents say they believe China s investment environment is improving. Therefore, the main idea is that the increase in market share in China is easier when putting already a foot in the country. - There is a growing percentage of FDI operated through local affiliates of foreign firms in China and they tend to acquire a higher share of capital (%). In fact, looking at COFM data, a major part of M&A are directly undertaken by parent companies, but it tends to decrease over the past few years. The next graph, that represents the share of the number of operations operated by foreign investors through their subsidiary in China and their average share of capital acquired, clearly shows the strong correlation between these two growing percentages (FDI operated through local affiliates and share of capital acquired). A report written by TAC - Applied Economic & Financial Research 46

51 Foreign M&A in China through their subsidiary in China 4.2 A positive reversal on FDI and ODI Since January 2013, TAC has started to build its own proprietary tool, to better monitoring individual Greenfield operations and reinforcing the global approach. This in-depth research not only consists in investigating the best way to follow Greenfield operations but also serves as an opportunity to enhance our methodology. This report is therefore based on preliminary Greenfield investment estimates for 2012Q4 and 2013Q1, while the remaining sample outside this period is based on our traditional sources of information for M&A and Greenfield investments. The estimated FDI inflows into China for 2013Q1 widely increased to reach USD 29.1bn and confirming the rebound in FDI inflows observed since 2012Q3 despite domestic and external uncertainties. This record is explained by strong Greenfield investment projects such as the huge project of Volkswagen to put USD 12.7bn into plant investments and research and development in China in the next few years. Its aggressive strategy is clearly to crowd out competition in a more constrained environment since Chinese authorities moved the automotive sector from encouraged to permitted sector in the last revised FDI catalogue. More specifically, China pushes foreign automotive companies to transfer know-how by establishing new brands (through jointventures) especially devoted to the Chinese market. Moreover, remarkable amount of M&A also fed the huge FDI inflows in 2013Q1 (equalling USD 11.6bn) thanks to a USD 9.4bn deal of Ping An Insurance, a provider of insurance services, by an investor group from Thailand (comprised of All Grain Trading Ltd, Bloom Fortune Group Ltd, Business Fortune Ltd and Easy Boom Developments Ltd). In parallel, massive Chinese investments were also operated abroad over the first quarter of 2013, reaching USD 30.0bn. China registered over this quarter a record with the USD 19.1bn acquisition by China National Offshore Oil Corporation (CNOOC) of Nexen Inc., a Calgary-based oil and gas exploration and production company. The second important deal concerns the USD 4.3bn Hengyi petrochemical Brunei project, which has finally got approval from the National Development and Reform Committe (NDRC). A report written by TAC - Applied Economic & Financial Research 47

52 Rolling 4-quarter FDI inflows into China Rolling 4-quarter FDI outflows from China FDI inflows into China - Number of operations Outflows M&A from China-Number of Operations However, such performances are to be taken cautiously as at the opposite, both the number of operations registered by China abroad and into China by foreign investors declined, suggesting global uncertainties. Indeed, we find strong correlation between MOFCOM figures and COFM figures on M&A which both confirm the slowdown. In parallel, the number of M&A from China is clearly below the historical positive trend. Looking at the recent quarters, FDI from Asia and EU27 were strong and increased (respectively at USD 13.0bn and USD 14.5bn in 2013Q1) while the US investments into China have decreased and were relatively small at USD 1.0bn in 2013Q1. However, the surge in FDI inflows in 2013Q1 was mainly explained by an increase in M&A from Asian countries, particularly from Hong Kong and the important Greenfield project by Volskwagen in China (USD 12.7bn). Historically speaking, while the share of FDI inflows from Asia is relatively stable since 2009 (35%-45%), EU27 progressively increased from 19% in 2010 to 34% in A report written by TAC - Applied Economic & Financial Research 48

53 FDI inflows into China by region (USD bn) In terms of Greenfield investments, the South Korean electronics giant Samsung announced last January that it plans to invest USD 1.7bn in expanding and fitting out its operations in Kunshan, a fast-growing manufacturing hub west of Shanghai. The electronic/software/it, automotive/transport and chemicals sector are rapidly expanding in China. Moreover, other sectors such as the healthcare sector, the financial services and the real estate, are emerging. Meanwhile, commodities & materials remains an important sector for foreign investments. FDI inflows into China by region since 2009 (USD bn) But massive investments were also operated by China abroad over the first quarter of 2013, reaching a record at USD 30bn. The largest deal concerns the USD 19.1bn acquisition by China National Offshore Oil Corporation (CNOOC) of Nexen Inc, a Calgary-based oil and gas exploration and production company. A second important deal concerns the USD 4.3bn Hengyi petrochemical Brunei project, which has finally got approval from the National Development and Reform Committee (NDRC) to produce 8mn tonnes/year. A report written by TAC - Applied Economic & Financial Research 49

54 Overall, COFM data registered 7 large Chinese M&A abroad (> USD 100mn) concentrated in Canada, Australia, USA and Brazil. They mostly reflect resource-seeking FDI, targeting the energy sector and the food and beverages (e.g. the USD 19.1bn acquisition by CNOOC of Nexen in Canada and the USD 280mn acquisition of Cubbie Group in Australia by an investor group). In parallel, deals were also operated in the high-end manufacturing and knowledge-intensive sector (in the automotive, commodities & materials, equipment), such as the USD 257mn acquisition by Wanxiang Group Co., China s biggest auto-parts maker, of the bankrupt electric-car battery maker A123 Systems Inc. No major deals were operated in the EU27 over the first quarter of Only 6 M&A were registered in 2013Q1 (2 in Germany, 2 in France, 1 in Denmark and 1 in UK) and one Greenfield investment in UK. 4.3 A focus on transit countries The objective of this section is to improve the understanding of the process used by foreign investors to enter the Chinese market but also the way Chinese companies invest abroad. It particularly concentrates on Hong Kong, as an important gateway for foreign investment in China but also for China s investment in the rest of the world. A report written by TAC - Applied Economic & Financial Research 50

55 Indeed, MOFCOM figures reveal that Hong Kong is by far the main FDI partner of China with Hong Kong increasing their FDI into China from 17% of total FDI inflows in 2005 to 38% in Conversely, according to MOFCOM data, Chinese companies operated on average half of their foreign investment in Hong Kong with a peak during the Global Financial Crisis at 69% and 63% in However, most analysts argue that quite a large proportion of the Mainland s capital invested in Hong Kong uses the territory as a base for making investments in other parts of the world as well as Hong Kong FDI into China. Indeed, Hong Kong has been used as a major financial centre for facilitating capital flows into and out of China because of the availability of diverse financing channels, easy approving procedures etc. Share of Hong Kong in China FDI flows (% of total) COFM figures can be helpful to clarify the role of Hong Kong in China FDI and more generally the usual road to invest into and from China by looking at countries who serve as transit. Indeed, COFM provides a more accurate measurement of the real new FDI while, as previously mentioned, MOFCOM provide information on the actual use of foreign investment including reinvested earnings, inter-company debt transactions, loans etc. Moreover, there is a high suspicion that MOFCOM data includes round-tripping capital from China to Hong Kong and back into China as FDI to take advantage of the more liberal Chinese laws and regulation afforded to foreign invested enterprises (FIEs). Such round-tripping effects are not taking into account in COFM data because they are filtered and more accurately classified as domestic investment. It is worth reminding that we record foreign FDI into China when the ultimate parent company is not originated from China and the target country is China. Similar opposite definition is used to record Chinese M&A abroad. We focus in this section on M&A because information about Greenfield investments generally do not detail information related to the transit country. Overall, M&A have equalled on average 30% of total amount invested in China and 62% of Chinese M&A invested abroad since Therefore, we question in this section the localization of the affiliate used to proceed the deal. Focusing on real new FDI, COFM figures draw a very different picture than MOFCOM data. Overall, statistics show that foreign countries mostly invest in China without transiting by another country. However, this trend seems to decline over the recent years, equalling on average 74% of total in from 79% in In parallel, foreign investors increasingly invest in China through their local affiliates representing 20% of the number of operations in 2012 from 14% in Then, Hong Kong is only used as a transit for around 3% of the number of operations, except in 2009 with a remarkable 7% of total and in 2012 with 5% of total. Conversely, similar observation can be done looking at the number of FDI outflows from China. Indeed, while it represents the major share of FDI outflows, the number of FDI operated directly by the Chinese companies without transiting by another country has decreased in to reach around 68% of total, compensated A report written by TAC - Applied Economic & Financial Research 51

56 by an increase of Chinese FDI operated through their affiliate in foreign countries. Moreover, the share of FDI transiting by Hong Kong has been multiplied by at least 3 over the recent years, from 2% in 2007 to 6%-8% over Number of FDI inflows into China by transit Number of FDI outflows from China by transit Interestingly, the analysis of figures reveals that different strategies exist depending on the sector of interest. For instance, foreign companies mostly transit by Hong Kong in the aerospace sector (20% of the number of operations), the food and beverages (7%) and the equipment (6%). Then, between 20%-25% of deals in the biotechnology, real estate, retailing and energy sectors were operated through their subsidiary in China. Finally, foreign companies directly invest in China in the electronic/software/it (82%), the chemicals (82%), the financial services (81%), the healthcare (81%) and the tourism (80%). Number of FDI inflows into China by transit and sector ( Q1) Chinese companies also invested through their subsidiary abroad in the biotechnology (33%), the real estate (45%), the financial services (25%) the energy (27%) and food and beverages (20%). Conversely, Chinese companies mostly transited by Hong Kong to invest in the healthcare sector abroad (with 15% of total). Finally, the chemicals, the aerospace, the tourism, the other services are among sectors in which China directly operated (without transiting by another countries), surely explained by easier access to those markets. A report written by TAC - Applied Economic & Financial Research 52

57 Number of FDI outflows from China by transit and sector ( Q1) A report written by TAC - Applied Economic & Financial Research 53

58 5 Focus on China s current account dynamics and medium-term prospects Following the Ming dynasty that was witness to a period of considerable foreign trade and the 15th century Ming Voyages, the foreign trade limitations of the Qing dynasty and the near 40 year ban on trade, the new leadership is now at an important juncture where a fine balance will be sought between the two in their attempt to ameliorate the external imbalance via a process of internal rebalancing. To better understand the chances of success underlying this trapeze act, we examine the following issues: the historical evolution of the current account, saving-investment dynamics at a sectorial level, and medium-term prospects. Key Elements After closely following investment, aggregate savings (% of GDP) surged from 2000 onwards in two distinctive stages: and The strongest gains were recorded during the first period and it peaked in the second at above 50%. The trade deficit in oil since 2003 has considerably widened, particularly after 2008, and appears to have stabilized in Meanwhile, the trade shortfall in Ores, Slag and Ash as well as Copper and articles thereof has steadily grown over the past three years. Compared to all its trade partners, China generally has the largest trade deficits with commodity producers. Australia, Saudi Arabia, Angola, Malaysia, and Brazil are among the top 10 trade deficit markets. Since 2001, Angola has observed the strongest deficit expansion while India displays the most notable surplus expansion with China. Over the past five years, the drastic drop in the current account seems to root from a combination of factors, including elevated investment levels, a weak global environment, and commodity price gains that have generally outstripped export price advances. A decline in savings will help to rebalance the internal and external imbalance; however, this will be difficult if investment decreases at a faster rate. Historical precedence highlights generally two types of rebalancing episodes: (1) crisis and (2) gradual transition (e.g. Taiwan and Japan). The latter category offers examples of mixed success. An attempt to rectify the internal and external imbalance is expected to apply downward pressure on China s current account surplus over the medium-term, averaging below 2% over the course of the 12 th 5-Year Plan ( ). This will appear to have a relatively negligible impact on the EU s trade balance with China whereas a deficit expansion is expected for the US. Meanwhile, Korea is set to see the pace of expansion in its trade surplus with China stagnate, following four years of robust gains. A report written by TAC - Applied Economic & Financial Research 54

59 5.1 Introduction: Historical current account dynamics The current account has seen a tremendous rise over the past two decades. Since formally announcing a shift from a centrally planned to a market-led economy, the current account (% of GDP) climbed from -1.9 in 1993 to a peak of 10.1 in Although mustering a respectable rebound after a difficult transition in the 1990s, much of this gain was apparent from 2001 onwards aided by WTO ascension and reform activities related to the 10 th Five-Year Plan ( ), which aimed to upgrade the industrial structure and strengthen international competitiveness. Over the past five years, the drastic drop in the current account seems to root from a combination of factors, including elevated investment levels, a weak global environment, and commodity price gains that have generally outstripped export price advances. Current Account Surplus Takes Off from 2000 Elevated Copper and Oil Prices Driving Import Prices During the same time horizon, the top 3 goods within which China had a trade surplus shifted noticeably to higher value-added goods. Specifically, the shift occurred from Articles of apparel, Footwear, and Toys in 2001 to Machinery, Electrical equipment, and Articles of apparel in Meanwhile, Mineral fuels and Ores have remained the leading deficit products, their importance growing markedly over the years, while Copper comes in at a distant third. Commodity Trade Deficit Widening Transportation Services Deficit Rapidly Expands The services trade balance, alternatively, has remained in deficit territory since at least 2001, with Transportation and Insurance services showing notable widening over time while the Travel services balance A report written by TAC - Applied Economic & Financial Research 55

60 turned strongly negative after Other Business, Construction, and Computer and Information services have on the whole registered the strongest trade surplus expansion. Based on the above trade balance decomposition by product one quickly realizes that China tends to have a trade deficit with commodity producers, save for a few exceptions, and a surplus with large manufacturers. For instance, aside from Japan, Korea, and Germany, the rest of the top 10 partners with which China has a deficit are commodity producers (e.g. Australia, Saudi Arabia, Angola, and Brazil). In terms of trade surplus partners, at the top of list are the US, Netherlands, United Kingdom, and India. However, when one considers the growth trend over time a few countries stand out. Angola, Saudi Arabia, and Australia are in the vanguard with respect to deficit gains while India, Turkey, and Vietnam lead on the surplus end. China Deficit with Oil and Metals Exporters Widens China Surplus with India Displays Marked Gain Critical among the objectives of the 12 th Five-Year Plan is the aim to reorient the economy towards consumption-led efficiency-focused growth. This is expected to render some tectonic shifts in the country s economic structure, including the expansion of the services industry by 4 percentage points to 47% of GDP by Hence, this will favor sectors such as Tourism, Consumer electronics, Food and consumables, and IT services. Undeniably, countries with which China has a large commodity-related (excluding soft commodities) trade deficit will likely feel the brunt of this policy action. First among the list of countries are metals (e.g. Australia and Chile) and then oil producers (e.g. Angola and Saudi Arabia). More importantly, this shift to consumption led growth will require a significant change in household consumption behavior. In the subsequent section a Flow of Funds approach is utilized to examine the dynamics of saving and investment in China with the intention to understand the underlying drivers of the current account. 5.1 Current Account: An alternative perspective There are generally two routes commonly traversed when analyzing current account dynamics: (1) externally and (2) internally. The first relies relatively more on trade-related components and the exchange rate, tackling the issue of current account movements via the external sector, whereas the second employs the use of underlying drivers of savings and investments, explaining evolutions in the current account via the domestic sector. In the first approach, the Gross Domestic Product (GDP) of a country is broken down using the following formula: (1) A report written by TAC - Applied Economic & Financial Research 56

61 where C equals consumption, I investment, G government spending, (X-M) net demand from abroad, S savings and T taxes, GNP Gross National Product and R net income from abroad. As the current account (CA) can be defined as the sum of net exports (X-M) plus net income from abroad (R), it is therefore also equal to savings minus investment plus taxes minus public spending: For the second approach, Obstfeld and Rogoff (1996) show that this relationship can also be explained intertemporally with the following equations: Herein,,,,,, and denote output, real interest rate, net foreign assets, consumption, government spending, and investment. The idea goes as follows. A country s current account can be defined as the change in the value of net foreign claims ( ) on the rest of the world. Hence, when in surplus the country is said to be a lender and a creditor when in deficit. Recall that a surplus country must be acquiring foreign assets of equal value because it is selling more to its foreign counterpart than it is buying while for a deficit country this outcome is reversed. This is apparent in the Balance of Payments wherein a country s net sale/purchase of assets is recorded in the capital account. If one considers equation (1), the first six variables on the right-hand side can be interpreted as the difference between national income ( ) and consumption, which gives the savings equation (2). Hence, this leaves us with the saving-investment spread as an alternative characterization of the current account balance. A conclusive theory on savings and its determinants remains elusive; however, the benchmark theoretical frameworks remain the life-cycle and permanent income models, both of which highlight the strong relationship between income growth and age structure. Moreover, Attanasio and Weber (2010) show that a general consensus has evolved around the significance of economic activity, demographics changes, and certain structural variables as key drivers. In what follows we survey the extant literature and utilize China s Flow of Funds data to analyze the saving-investment behavior of the household and private sector. In addition to Singapore and Malaysia, Donghyun and Shin (2009) find that China is among a handful of Asian countries with saving rates that have historically exceeded the regional average. Although the nation officially began its transition from a centrally planned to a market-led system in 1993, Kraay (2000) highlights that remnants were inherited from the previous system (e.g. favoring state-led over market-driven investment and high domestic savings), particularly the household s central role as the key sectoral funding source. Ever since this function was seceded by the public to the household sector in the 1980s, owing to reforms and rising income, the household has been at the top of the savings hierarchy. By the Eighth 5-Year Plan ( ), business sector savings surpassed that of the public sector. With households on top followed by the business and public sector, this pyramid has remained more or less intact for more than 20 years. Given the combination of large domestic savings and a relatively closed capital account, the bulk of investment has been domestically financed. Moreover, despite the diminished role of the government sector, Louis (2006) and others assert that the size of business sector savings is largely a byproduct of policies particular to China. Altogether, the high level of savings has until now supported the country s capital-intensive, export-led growth model. (3) (4) (5) (6) A report written by TAC - Applied Economic & Financial Research 57

62 Savings Historically Above Global Average Savings-Investment Gap grew since early-2000s After closely following investment for some time, total savings (% of GDP) surged from 2000 onwards, bolstered by an unprecedented streak of robust real income per capita gains, as well as the current account surplus. This developed in two distinctive stages: and The strongest gains were recorded during the first period, wherein it increased by 10 percentage points, and thereafter peaked in the second period at slightly above 50%. Several potential explanations have been advanced to explain this jump, including: financial market imperfections, the growing importance of processing trade, exchange rate intervention, limits on investment in productive capacity, and the pursuit of an export-led development strategy. To some extent this may have been state engineered, but the fact that a policy target for the 11 th 5- Year Plan ( ) was a balanced current account and not a surplus of 10% (2007) suggests that the authorities were caught off guard. a. Household sector: Inherited savings pyramid more or less intact Using the Flow of Funds data, it is possible to examine a decomposition of domestic savings into sectoral components. The household sector remains the largest saver, accounting for nearly 50% of domestic savings by the end of The fundamental role of this sector within China s economy has essentially been to serve as an important wellspring of excess savings, channeled via the banking system, to supplement private sector investment activity which helps to understand the sector s low and steady share in total domestic investment of about 20%. Household Sector a Wellspring of Excess Savings Savings Rise with the Fall in Age Dependency A report written by TAC - Applied Economic & Financial Research 58

63 Aside from reasons related to inherited policies from the central planning era, the literature points to other factors that motivated and preserved the household s considerable domestic savings share. These include: the age-earnings profile of younger versus older Chinese workers; underdevelopment of public and private pension systems; demographic changes (e.g. aging population, one-child policy, gender imbalance); and the transition from public to private provisioning of education, health care, and housing. Population control policies and the structural demographic consequences continue to have significant impact on household savings. In fact, Modigliani and Cao (2004) show that the shift in demographic structure, as an outgrowth of the one-child policy, is one vital factor that raised savings. Moreover, Ge, Yang, and Zhang (2012) explain that a reduction of adult children within a Chinese household obliges the household leader(s) to save more for old-age security. Interestingly, the common inverted U- shaped saving distribution of households, wherein the middle-aged population save the most, turned upside down from and saw the younger and older segment saving more than the working-age population. First documented by Chamon and Prasad (2010) for select provinces, Song and Yang (2010) highlight this fact for all households. According to the aforementioned authors, this was due to a robust upturn in wages for successive younger cohorts and a decline in the aggregate pension replacement rate, i.e. ratio of average pension per retiree to wages per worker. For the former, this has helped to further flatten the age-earnings profile, a drastic change from the 1980s when seniority was highly regarded and earnings did not necessarily reflect merit. b. Private sector: Reforms beget an investment champion On the other hand, the business along with the public sector contributed significantly to the rise in savings since In fact, by the late 2000s the share of public sector savings as a % of the domestic total returned to 1990 levels (2009: 10%) while enterprise savings grew to a size that vied with households. The strong performance in enterprise savings was supported by a number of structural reforms in the early 2000s. In line with Ma and Yi (2010), Yang et al. (2011), and others, enterprise savings is considered equivalent to the total disposable income of the business sector. An increase in profits does not necessarily result in an increase in aggregate savings; however, it is important to note that the private sector in China retains a significant portion of these profit gains. According to Kuijs (2006), more than 70% of enterprise investment is financed through retained earnings. Furthermore, Song, Storesletten, and Zilibotti (2011) indicate that for reasons related to credit creation control by state banks, which have a bias towards other state enterprises, private firms often meet funding needs by taping internal savings. Business Sector a Saving and Investment Source Government has Influence on Credit Decisions A report written by TAC - Applied Economic & Financial Research 59

64 Funding mechanism aside, the private sector stood to benefit from the economic reforms of the late 1990s. Among others, the reforms also involved the relaxation of worker mobility restrictions and the privatization of several state-owned enterprises. In turn, labor productivity climbed amid subdued wage increases and low interest and rental land rates, thereby augmenting business profits in the process. According to Ge and Yang (2012), average real wages increased 2 percentage points below real economic growth from Furthermore, upon entry to the WTO in 2001 the consequent decline in tariffs and trade barriers aided a notable expansion in external demand. Meanwhile, total investment (% of GDP) from climbed by more than 10 percentage points, stemming from a joint effort between households and the private sector. In terms of domestic investment, the private sector holds a central position, representing about 68% of total domestic investment in According to Kuijs (2006), it is this dominant role of the business sector that sets China apart from others. Consequently, this very function has ensured a sectoral deficit, i.e. I > S, every year since at least the mid-1990s while in the process partially offsetting the notable surplus, i.e. S > I, in the household sector. Nonetheless, investment did stagnate from due to government intervention to ease concerns of overheating. Yang (2012) asserts that in 2005 the authorities sought to stabilize investment by introducing a list of prohibited industries that should avoid further investment, which included heavy industries. Although firms managed to redirect investment elsewhere, the household and government sector saw either a decline or stagnation. This is a useful reminder that investment for the moment is to some extent centralized, as the authorities whether directly (e.g. investment promotion/prohibition) or indirectly (e.g. influence over SOE loan disbursement) have considerable sway; however, this is not the case with savings. c. Outlook: Historical precedence shows mixed success in rebalancing efforts The large surplus in the household sector and the near balance level in the public sector have been sufficient to compensate for the deficit in the private sector, ensuring that the current account surplus remains relatively large. However, for a number of reasons it is likely that total savings will decline over the next decade. China s Savings Growth Easing with Rise in Income Subsiding Productivity to Follow Expansion in Services At least three reasons stand out: 1) firms have less scope to benefit from cost saving and efficiency gains from factor price distortions that created uncertainties for households; 2) there are tentative signs of an approaching Lewis Turning Point, the point at which an economy essentially exhausts excess labor supply; and 3) Demographic headwinds of the 1990s and 2000s are fading, if not turning into tailwinds. First, economic reforms as part of the 12th 5-Year Plan involve steps towards closing the productivity-wage gap (e.g. nearly doubling the minimum wage to 1,603 Yuan by 2015), liberalizing interest rates, and improving social welfare benefits. Altogether, this is envisaged to support the 5 percentage point decrease in savings in order to secure the 2015 consumption target of 40% of GDP. Secondly, Garnaut (2010) and others have indicated that the A report written by TAC - Applied Economic & Financial Research 60

65 country is close to, if not already at, the threshold where excess labor supply is exhausted, indicating that even without reform intervention demographic changes are set to place upward pressure on wages going forward. According to Das and N Diaye (2013), this will emerge between 2020 and 2025, with greater financial and product market reform expected to bring the date closer. Moreover, the non-linear trend between savings and income per capita suggests that savings in China are set to slow in line with rising per capita income. Lastly, UN projections show that the working-age population may have already peaked and could shrink for the next 10 years, lowering the participation rate and leading to lower potential growth unless a proportional rise in labour productivity is observed. Taiwan: Labour Cost and Current Account Transition Japan: Labour Cost and Current Account Transition A decline in savings will help to rebalance the internal and external imbalance; however, this will be difficult if investment decreases at a faster rate. Historical precedence highlights generally two types of rebalancing episodes: (1) crisis and (2) gradual transition (e.g. Taiwan and Japan). The latter category offers examples of mixed success. For Taiwan, reforms were applied during the late-1970s and early-1980s in an attempt to rebalance the economy, which managed to gradually stimulate household consumption from the mid-1980s onward while the current account surplus declined by a marked 13 percentage points (1986: 21% of GDP) to 8.4% of GDP within a two year span. For Japan, on the other hand, domestic rebalancing in the 1970s had its own setbacks during the transition phase, most notably the fact that after witnessing a current account surplus decline it began to widen strongly shortly thereafter, as investment decelerated at a greater rate than the deceleration in savings. Taiwan: Internal Rebalancing Japan: Internal Rebalancing A report written by TAC - Applied Economic & Financial Research 61

66 Notwithstanding the structural differences between Taiwan and Japan, both can serve as examples from which to extract some insight into the potential success rate of a gradual transition. If the results of Lee et al. (2013) hold, China s current account risks repeating Japan s difficult transition if the authorities reduce investment without carefully discriminating between industries. Their results show that since 2000 private consumption has been significantly dependent on investment, with little evidence in the opposite direction, and that the instant effect is the largest. However, this impact on consumption can be mitigated if investment is redirected towards industries that boost household income, i.e. services and agriculture. 5.2 Estimation: medium-term trend of surplus set to head south Using the extant literature, a model was constructed to forecast the current account via the use of an investment and savings equation. For investment, econometric tests reveal that in addition to economic growth structural and demographic variables (e.g. old-age dependency, industry share of GDP, life expectancy) also have an impact. For savings, variables such as income per capita and total dependency came in as significant determining factors, coinciding with other empirical studies. With the use of UN demographic and IMF growth projections to inform our assumptions on dynamics over the coming years, our results point to a steady decline in both savings and investment. Our baseline projection suggests that investment will likely decline modestly to about the mid 40s by 2016, which is close to what Lee et al. (2012) purport is sufficient to bring it in line with fundamentals. It is important to recall that studies have shown that investment often leads consumption. Given its influence over investment, the government may seek to boost consumption by increasing investment in consumptionsupportive sectors, which aligns with the 12 th 5-Year Plan ( ) to raise service sector value-added output % of GDP by 4 percentage points to 47%. That would imply a more subdued decline in investment. Likewise, faced with demographic changes, rising income, improving social welfare benefits and a squeeze on corporate net profit margins, savings is expected to decrease over the same period, registering an estimated decline of 5 percentage points. An important question is whether the pace of deceleration in savings will exceed or lag investment. Up until 2015 savings appear to be in the vanguard, but we begin to see a change in leadership around Savings Decline to Generally Lead Investment Going Forward The current account is estimated to average a small surplus through the 12 th 5-Year Plan ( ), however the long-term structural trend highlights a general convergence of savings and investment, which given the right conditions can support a current account deficit over the medium-term. As alluded to in the illustration below, solely considering the structural elements of the current account supports a mild deficit going forward. However, it does not take into account net investment income. Given that foreign exchange reserves have grown considerably over the past years, it is likely that net investment income is set to see a non-negligible pickup in the coming years. Hence, if this is adjusted for, the current account should manage to sustain a A report written by TAC - Applied Economic & Financial Research 62

67 surplus, albeit slight, over the medium-term. Moreover, the risks to investment are largely to the downside and by extension on the upside for the current account balance. Current Account to Average a Modest Surplus through the 12 th 5-Year Plan Altogether, this seems to mimic Japan s current account trajectory more so than Taiwan. Nonetheless, China today is not Japan in the 1970s. Among other things, Japan was not exposed to a Hukou system, a type of registration system wherein Chinese rural migrants receive little social benefits while living in cities, or face a similar government land purchase system, which has benefited local governments relatively more than farmers. In fact, Huang (2010) shows that despite improving the income level of many, the urbanization process may have also raised precautionary savings. The Chinese authorities are aware of these impediments to savings and are putting reforms in place to offset these factors. For instance, in addition to a 13% annual increase in the minimum wage, the 12 th 5-Year Plan is introducing mandatory employer welfare contributions, which includes contributions to pensions, unemployment benefits, medical insurance, and housing entitlements. These reforms and others like this will serve to support the decline in savings and potentially evade a Japan scenario. EU-China Trade Deficit to Remain Steady If China is envisaged to see its current account surplus decline going forward, it would be reasonable to ask what deficit/surplus countries are vulnerable. In attempting to answer this question, a model was constructed to estimate the trade balance over the next couple quarters for the EU, US, and Korea. Relatively stable out to the beginning of 2015, the EU s trade deficit with China is estimated to show a steady quarterly advance, ranging between EUR 48bn EUR 35bn. The US, on the other hand, is estimated to see a relatively strong increase in its trade deficit with China, largely driven by rising US growth momentum amid relative stagnation in China. Meanwhile, aside from the 2014Q4 uptick, estimates for Korea show stabilization from 2013Q4 A report written by TAC - Applied Economic & Financial Research 63

68 onwards, following four years of expansion. This is understandable given that the country has the largest trade surplus with China. US-China Trade Deficit to Widen Further Rise in Korea-China Trade Surplus to Stabilize In sum, an attempt at internal and external rebalancing is expected to apply downward pressure on China s current account surplus over the medium-term. Savings should lead the decline, however, there are indications that this may change in Effective reform implementation has the potential to ensure that this leadership change does not occur. Large capital-intensive exporters, like Korea, may see the pace of expansion in their trade balance ease while commodity exporters, particularly metal and oil producers, appear most vulnerable. 5.3 References Attanasio, O. P. And Weber, G. (2010). Consumption and Saving: Models of Intertemporal Allocation and Their Implications for Public Policy, NBER Working Paper Series, no Chamon, M. and Prasad, E. (2010). Why are Saving Rates of Urban Households in China Rising?, American Economic Journal: Macroeconomics, vol. 2, no. 1. Das, M. And N Diaye, P. (2013). Chronicle of a Decline Foretold: Has China Reached the Lewis Turning Point?, IMF Working Paper. Fungacova, Z. And Korhonen, Likka (2011). Like China, the Chinese Banking Sector is in a Class of its Own, BOFIT Discussion Papers, no. 32. Garnaut, Ross (2010). Marco-Economic Implications of the Turning Point, China Economic Journal, vol. 3, no. 2. Ge, S. and Yang, D. T. (2012). Changes in China s Wage Structure. IZA Discussion Paper, no Ge, S., Yang, D. T., and Zhang, J. (2012). Population Policies, Demographic Structural Changes, and the Chinese Household Saving Puzzle, IZA Discussion Paper, no Huang, Yasheng (2010). Urbanization, Hukou System and Government Land Ownership: Effects on Rural Migrant Workers and on Rural and Urban Hukou Residents, OECD Global Development Outlook Kraay, Aart (2000). Household Savings in China, World Bank Economic Review. Kuijs, Louis (2005). Investment and Savings in China, World Bank Policy Research Working Paper, no Kuijs, Louis (2006). How Will China s Saving-Investment Balance Evolve?, World Bank China Research Paper, no. 4. Lardy, N. And Borst, N. (2013). A Blueprint for Rebalancing the Chinese Economy, PIIE Policy Brief, no. PB Lee, I. H., Syed, M., and Xueyan, L. (2012). Is China Over-Investing and Does it Matter?, IMF Working Paper. A report written by TAC - Applied Economic & Financial Research 64