International Investment Studies
Quarterly Report No.201419
November 6, 2014
China’s Fading Twin Surpluses and its Policy Implications
——《2014年第3季度中国跨境资本流动报告》之专题报告
张明 谭小芬
Abstract
This paper argues that the twin surpluses of China’s balance of payment tend to vanish in the future due to some external and internal structural changes. China’s current account surplus would diminish due to the decline of good trade surplus and the expanding service trade deficit and negative investment income. China’s capital account surplus might turn into deficit as a result of shrinking net direct investment income and rising volatile short-term capital flows. The fading twin surpluses would speed up the normalization of US treasury bond yields, terminate the one way appreciation of RMB exchange rate, alleviate PBC’s sterilization pressure as well as cause new problem for PBC, and pose new financial vulnerability to Chinese economy. Finally, this paper provides some policy suggestions to deal with the new challenges brought by the shrinking twin surpluses.
Key words: China, twin surpluses, capital account liberalization, financial risk
I. Introduction
China experienced both current account surplus and capital account2 surplus in its balance of payments for 13 consecutive years from 1999 to 2011 (Figure 1). As a result of this twin surpluses, China’s foreign exchange reserve rose from USD 155 billion at the end of 1999 to USD 3.8 trillion at the end of 2013. The persistent twin surpluses were deemed as a symptom of China’s external imbalance, which contributed significantly to the global current account imbalance in 2000s. The sharp rising of foreign exchange reserve was regarded as an evidence of People’s Bank of China (PBC)‘s intervention on foreign exchange market, which was commonly cited as an argument for foreign countries (especially the United States) to pressure RMB to appreciate (Figure 2).
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II. The Evolution of China’s Current Account Balance
As shown in Figure 3, the ratio of current account surplus to GDP declined markedly after 2008, which indicates that China’s current account imbalance has already been significantly alleviated. However, whether the decline of current account to GDP ratio was caused by cyclical factors or structural factors remains a question mark. On the one hand, some economists argued that the declining of China’s current account surplus resulted from the surging of domestic investment after the burst of global financial crisis, which shrank the saving investment gap and therefore pushed down the current account surplus. Along this logic, China may face the rising of current account surplus again once the domestic investment level goes down due to the exacerbation of excess capacity. On the other hand, if the shrinking of current account to GDP ratio was caused by structural factors, China’s current account would be more balanced in the future.
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III. The Evolution of China’s Capital Account Balance
As can be seen from both figure 1 and figure 3, the volatility of China’s capital account balance is much higher than that of current account balance. To analyze the evolution of China’s capital account, we should also decompose the capital account into more specific items, and then analyze the evolution of each item respectively. Figure 10 demonstrates the three major components of China’s capital account. From it we can see that direct investment flow is relatively stable, and other investment flow is relatively volatile. As table 1 illustrates, direct investment flow is not only the major contributor of China’s capital account surplus but also the most stable type (the coefficient of deviation is only 166%), however other investment flow is the major component of capital outflow and also the most volatile type (the coefficient of deviation reaches 734%). The average level of portfolio investment flow is the smallest, but its volatility is higher than direct investment flow.
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IV. The Policy Implications for China’s Fading Twin Surpluses
The gradual fading twin surpluses on China’s balance of payment would have important policy implications not only for Chinese economy but also for global financial market, especially U.S. government bond market.
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V. Conclusion
China has been facing both current account surplus and capital account surplus for over a decade. However, the twin surpluses would fade in the future due to some structural factors. The liberalization of domestic factors, the appreciation of RMB exchange rate and the weak external demand would push down good trade surplus. The opening up of Chinese service sector and financial market might expand service trade deficit and negative investment income. As a consequence, China’s current account surplus tends to shrink in the future. The structural adjustment of Chinese economy would weaken the incentive for FDI, but the incentive for domestic enterprises to invest abroad would strengthen under the support of Chinese government, which would reduce the net direct investment inflow. The scale of short-term capital flow would increase, but they are very volatile. Therefore, China’s capital account balance would face some uncertainty in the future. For example, capital account surplus may change into deficit in a short time.
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