Balance of Trade in the Future

China is facing a profound demographic transition with rapid population aging for decades to come

Michael Graff

Michael Graff worked as Economic Adviser for the Reserve Bank of New Zealand in Wellington (2003—2004), and was senior lecturer in economics at the University of Queensland in Brisbane (2005—2007). Since 2007, he is heading the Macroeconomic Forecasting Division at KOF Swiss Economic Institute at ETH Zurich. In 2012, he was awarded the title of Professor for Economics at ETH Zurich.

China's economic reforms, starting in 1978, paved the way for one of the most spectacular socioeconomic transformations in human history, concerning not only the number of people affected — roughly 20 percent of the world population throughout these years — but also the pace and depth of the transformation. The one child policy, adopted in 1979 and relaxed only recently, supported this transformation by freeing vast amounts of resources that would otherwise have to be devoted to child care and education.

During this period, labor shortage was not an issue, as the growing manufacturing and serviced industries could tap from a pool of hundreds of millions of potential workers from rural areas.Urbanization was thus both a driving factor and a result of this epochal change. From 1978 to 2017, China's urban population share increased from just 18 percent to 58 percent (and from 8 percent to 27 percent for agglomerations of more than 1 million inhabitants), whilst on the global scale, the increase was from 29 percent to 54 percent (16 percent to 23 percent for the larger agglomerations).

During the same period, China's GDP per capita grew at 8.5 percent per year on average, whilst for the world the corresponding number was less than 1.5 percent. By 2017, China's GDP per capita came close to 70 percent of the global average;corrected for purchasing power parity, it is now very close to the global average.

Economic growth has somewhat slowed down in recent years, and labor supply is no longer close to infinitely elastic, as urbanization has progressed so far and the fertility rate is not sufficient to reproduce the labor force. Associated with this, China is facing a profound demographic transition with rapid population aging for decades to come. Last but not least, the Trump administration is openly hostile to Chinese export surpluses and is obviously willing to engage in an escalating trade war. The 40thanniversary of China's reform and opening-up policy is a good opportunity for some fundamental considerations about the reasons for this success story and the main opportunities and challenges resulting from the present situation. I will focus exclusively on macroeconomic factors in this article.

The most widely acknowledged macroeconomic characteristic of China's transformation is the export-promoting strategy. Indeed, from a trade integration ([exports + imports]/GDP) of less than 10 percent in 1978, this ratio rose to close to 65 percent at its peak just before the global financial crisis and the resulting Great Recession. Having said this, from 2007 onward, the ratio fell back to somewhere below 40 percent, and the trend is almost monotonically decreasing, which indicates a regime shift may have been triggered by the slump of world trade. Regarding the balance of trade, however, such a regime shift does not appear in the data so far. As can be seen in Figure 1, for the first 15 years the opening-up policy saw increasing trade intensity with successive trade surpluses and deficits; but in the 1990s, this changed, and since 1994, there has not been a single year in which China has not recorded a sizeable trade surplus.

This stands out. Apart from primary goods exporters, only a handful of economies exhibit trade surpluses for protracted periods of time. Besides China, the only sizeable economy with a comparable record is Germany. As a country's trade surplus has to find a counterpart in a corresponding total global deficit,sizeable and protracted trade surpluses are widely held to be“neo-mercantilist” policies, and indeed, Donald Trump's electoral success can to some degree be attributed to support from regions that have undergone deindustrialization. If something (say, US automobiles) was manufactured here in the past and is manufactured somewhere abroad now the argument goes, “the foreigners stole our jobs”.

This reproach is certainly simplistic, ignoring the continuous transformation of the division of labor within economies as well as in the global economy, where industries either become increasingly sophisticated or relocated to regions that have just moved high enough on the quality ladder. Yet, in the export surplus countries, the dominant discourse echoes the very same story, praising the outstanding competitiveness of the domestic economy and the “job miracles” going along with it.

Now, moving from popular discourse to macroeconomics, what is good or bad about a protracted trade surplus or deficit? To make things simple, let us first assume that the world consists of two large economies, and one (S) is experiencing an eternal trade surplus, and the other (D) is the eternal deficit country. Furthermore, let us assume that the single objective of economic activity is to provide the material basis of a good life. In this case the answer is as simple as strikingly contrary to the general understanding of the virtue of being a net exporter. The population in D fares better than that in S in that it will forever consume more than it produces. Applying this to China, sending one container ship after the other across the Pacific, loaded to the brim with goods manufactured in China, and receiving them back after a few weeks half empty, or more precisely, loaded with US goods worth only a fraction of the outbound cargo —this cannot reasonably continue infinitely. The missing element here is of course that the half empty ships come with a promise to reverse this outcome at some stage in the future, materialized, say by huge bundles of dollar bills in the ship's strongbox. In economic terms, the longstanding net exporter is increasing its international net asset position, and as for any creditor, this is an entitlement to consume beyond one's means at some stage of the future — provided the debtor is able and willing to fulfil his obligations. Importantly, the latter condition becomes more and more crucial with the cumulative size of the trade surplus and the corresponding debt.

Before we assess the possible outcomes, let us have a look at the numbers for China. The statistics are not perfect, but they tell a plausible story. For the cumulative balance of trade surplus, we can resort to annual data from 1960 to 2017, expressed in current dollars. Since during this period, trade as well as international credit was chiefly expressed in dollars, and since credit and debt are generally expressed in nominal terms, the cumulative Chinese trade balance at the end of 2017 ($3,457,525,587,836) should roughly correspond to China's net foreign asset position. For the latter, we have numbers in domestic currency, starting 1977. For comparison, we compute the corresponding shares in Chinese current GDP. The results are shown in Figure 2.

Whilst there is an obvious correspondence between the two series (the correlation amounts to 0.94), for most of the period from 1977 to 2017, China's net foreign assets exhibit higher values than its cumulative trade surpluses. This is partly due to the fact that the external credit position is driven by the entire current account, not only the balance of trade, but valuation effects (market prices of the securities in which the claims are held and exchange rates) are certainly more important here. Starting in

the mid-1980s, the market value of China's net foreign assets, expressed in domestic currency, started to exceed the cumulative surplus. This gap continued to widen until 2008, when the global financial crisis wiped out huge amounts of nominal fortunes, and by the end of 2017, as it happens, the gap has been practically closed. Now China records a cumulative trade surplus of about 30 percent of its 2017 GDP and net foreign assets of about the same magnitude.

The good news from this is that the last 40 years of openingup have brought China to a favorable position to hold claims against the rest of the world corresponding to nearly one-third of its annual GDP. Also, the underlying excess of domestic production over domestic absorption has used a corresponding excess of domestic laborers. Accordingly, millions of jobs in China's exporting industries have been filled because of the trade surpluses. Also, as more production was taking place in China than otherwise, the Chinese tax base increased.

Now to the real or potential drawbacks. Contemporary economics is not too explicit about how to assess the welfare impacts of labor. The traditional view is that labor delivers disutility (dirt, sweat, fatigue). People trade their working hours strictly as a means to an end of earning an income. From this perspective, the assessment of the Chinese trade surplus rests on the rate of time preference as well as on the likelihood that the claims against the rest of the world can be executed without a discount.

There is of course the less precisely formulated concept that having a job is a beneficial outcome, compared to being unemployed. Culturally inherited work ethics as well as self-esteem from achievements at work play a role here, but more decisively, after the end of feudalism, participation in the labor market is the essential requirement to participate from the benefits that a market economy and the institutional superstructure has to offer to its have-nots. While it may be true that a superior society will decouple individual well-being from the labor market, for the last 40 years, the benefits of having a job can hardly be underestimated. But doubts remain regarding a sustainable long-term perspective to increase the domestic hours worked and to transfer the proceeds abroad, without any corresponding increase in consumption opportunities apart from the most uncertain promises regarding the future.

Future in our context translates into time preference and into uncertainty. Regarding time preference, economists assume that it must be higher the poorer an individual (a country) is, as the sacrifice of present consumption for later rewards is felt more painfully, the poorer one is. This would predict net capital flows from richer to poorer countries, and not in the opposite direction as implied by the Chinese trade surpluses with many of the richer economies of the world.

Also, as the asset value deflation from 2008 demonstrates, it is more than doubtful that China will be able to unwind its creditor position without massively deflating its real value. For a carefully planned unwinding, starting soon and stretching over a couple of decades, there is some risk that a real transfer of resources into China will not completely match the last decade's outflows, but some part of the credit could certainly by recovered. But this assumes that the world economy will operate as we know it now. Moving into the unforeseeable future, the bet on the future credibility of China's creditors cannot reasonably be expressed as a quantifiable risk. This implies that a timely reversal of the trade surplus is called for, unless one wants to assess its welfare implications under the assumption that the surplus essentially takes the character of donation to the rest of the world, where the intrinsic reward for China is represented by the millions of domestic workers having jobs which they otherwise would not have.

To sum up, whilst a protracted trade surplus is generally praised as an outright success story, at least in the countries sharing this experience, economic reasoning implies that this cannot (or indeed should not) continue infinitely. If domestic absorption is less than production, domestic savings will finance the surplus and the foreign debt, which is necessarily associated with it. In the long run, this is not advantageous, unless one considers domestic value added (and the jobs producing it) alone. A country can, in principle, consistently live below its means (absorption< production), with ever growing claims against the rest of the world. To execute these claims, however, the current account surplus must turn negative (absorption > production); otherwise the cumulative claims will never be met and the net foreign assets will ultimately be recorded as a loan to be written off, at least in part.

On the positive side, it is conceivable that a structural change from a net-exporting to a net-importing economy offers the opportunity to cushion the imminent demographic transition. An analogy to the private lifecycle hypothesis would correspond to a maturing economy that is saving, and then start to dissave until a new demographic equilibrium is established.