China's Trade Surplus May Be an Illusion
MAY 22, 2006 By Stephen Green, from http://www.businessweek.com
Standard Chartered Bank's senior
economist argues that the enormous
global trade surplus could be the result
of data smoke and mirrors
The export of fake goods out of China is
commonplace whether you are talking
about designer bags, blockbuster movie
DVDs, or "Mont Blanc" pens. Many
European and U.S. holidaymakers take
these knock-offs home with them -- some
of them knowing they're counterfeit;
others are unaware. Underground Chinese
firms spirit such goods out of the
mainland on a much larger scale.
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Now we may we have identified another
fake: the supposedly gargantuan global
trade surplus China enjoys with the rest
of the world. Much of China's trade
surplus in 2005 was not trade at all, we
think, but rather capital inflows
(perhaps as much as $67 billion)
disguised as trade. If so, this has
major implications for China's trade
policies, the yuan, and the way the U.S.
deals with China.
China shocked much of the world last
year when it reported that its global
trade surplus had more than tripled to
$102 billion or 4.5% of revised gross
domestic product. To some trade hawks
and U.S. congressmen this number
provided yet more evidence that Chinese
exports were contributing to the
hollowing out of the U.S. manufacturing
sector and stealing American jobs. And
they believed this was achieved
unfairly, that Beijing had manipulated
its currency and engaged in suspect
policies such as extending unfair
utilities subsidies to Chinese factories
and banning workers from joining trade
unions to give China an economic edge.
A CLOSER LOOK. Because of China's
comparative advantage in labor-intensive
manufacturing, plenty of others accepted
the big spike at face value. Given
China's international image as the
"world's factory," it made sense to them
that China's exports should have
swelled. But the sudden rise in the
number puzzled economists.
Why? Well, first, we know countries that
export a lot tend also to import a lot
-- and none more so than China. It's a
developing country with few natural
resources, dependent on Asian and
Western firms sending in components to
be assembled in coastal factories. As a
percentage of GDP, China's trade surplus
was actually declining through 1999 to
2004.
Economists also puzzled over what had
changed from 2004 (when the trade
account was only $32 billion) to 2005. A
big swing like that usually means
something serious is changing within the
domestic economy, such as either a big
increase in savings or a drop in
investment inside China's own borders.
But when we looked, we could not see
evidence of either scenario.
TRADE DISPARITY. So we took a closer
look at the trade figures. The biggest
puzzle was this: When you compare
China's trade numbers with those of its
key trade partners there are big
discrepancies -- as high as 80% in some
years. In theory, bi-lateral trade data
should show that China imports roughly
the same as, say, big trading partners
such as South Korea or the U.S. export
to the mainland. But in fact, China
imports far more than other countries
export to China and exports far less
than its neighbors import from it.
One explanation for this is
straightforward -- and not unique to
China. Compare any country's exports to
its partners' imports and you will also
find some disparity in how trade is
calculated. Exports are usually
calculated on a "free on board" basis --
meaning their value at the point of
customs. The value of imports is
generally treated differently and
includes things such as insurance and
freight costs.
Trade experts estimate that the
difference between exports and imports,
which are higher in value, is usually
about 15% of the value of the exports.
But that was not enough to explain the
huge gap that has existed between
China's numbers and its partners'. So we
turned to look at something special
about China's trade.
UNCLEAR DATA? A big chunk of mainland
goods pass through Hong Kong before
shipping out to overseas markets. And
how that is accounted for in the trade
data makes a world of difference.
Consider the differing approaches of
China and the U.S. on this score.
China does not count all of the goods
exported to the U.S. via Hong Kong so
its export number is likely to be
understated. Chinese trade authorities
say they make this exclusion because
their tracking data on the final
destination of the goods leaving Hong
Kong isn't always clear enough. The U.S.
Commerce Dept., meanwhile, considers all
exports out of the mainland that transit
through Hong Kong -- and that ultimately
arrive at U.S. ports -- in the final
tally of Chinese exports to the U.S.
Not only that, it includes the
value-added -- that is, the added
mark-up on the cost of goods that Hong
Kong trading firms impose for services
rendered -- in Hong Kong. This method of
trade accounting adds 20% to 30% more to
the total value of outbound mainland
goods, and we think the result is that
the U.S. export number for China is
exaggerated. As a result, the U.S. says
its bilateral deficit with China was
$202 billion in 2005, while China says
it was $114 billion. The correct answer
should be somewhere in between.
PLAYING DOCTOR. But that did not solve
our problem completely either, because
the trade gap remained. In fact, when we
looked at the gap as a percentage of
total trade, it has been falling since
2001. Although China exports less than
its trade partners import, it is now
exporting a lot more vis-á-vis partner
imports than four years ago.
So we played with the numbers some more
and believe we have found evidence that
there is a problem on the Chinese side
as well. Some mainland trading firms are
doctoring the export and import invoices
submitted to Chinese customs officials
to get around capital controls and bring
in more foreign hard currency than their
trade transactions would justify. The
economic incentive is clear enough: The
Chinese yuan is widely expected to
appreciate in the years ahead, and is an
attractive investment for companies or
speculators.
Why all the subterfuge? China's capital
account restrictions make it difficult
to bring U.S. dollars onshore and
convert that money into yuan for
domestic companies and ordinary Chinese
people. But Chinese exporters and
trading companies have a far easier
time, due to the nature of their
business. An exporter willing to
exaggerate an invoice handed over to
local authorities could bring far more
hard currency into the country than
warranted by the value of goods sold.
IN THE FAMILY. This "mis-invoicing" of
trade was commonplace in the last
decade, but back then it was a way of
getting money out of China. Now we think
it is being used to bring funds in,
given the strong likelihood the yuan
will appreciate in value relative to
foreign currencies down the road. This
again inflates the value of Chinese
exports.
The exaggeration in the value of Chinese
exports is probably getting another
boost from the phenomenon of transfer
pricing. This involves the price at
which transactions between units of
multinationals take place. When a
mainland company trades with a sister
company or affiliate offshore, the value
of goods depends a great deal on where
the company wants to book the profit.
Usually firms will ensure that profit on
trade transactions within a company are
booked in lower tax jurisdictions. And
that has usually meant offshore in the
past, given the relatively high tax
rates on the mainland compared to Hong
Kong and other regional economies.
PRE-SHIPPING PRICE. But with the yuan
now appreciating against many regional
currencies, that is starting to change.
Imagine a mainland-based laptop maker
with a production facility at home and a
subsidiary in Hong Kong. This Chinese
company has an order to sell a laptop
with a retail price of $1,000 to a
computer store chain in the U.S.
In the past, in order to minimize profit
and hence tax bills, the parent company
would sell the computer first to the
subsidiary at a price very close to the
actual cost of production, say $500, and
then the subsidiary would ship it off to
the States. Now, with the yuan starting
to appreciate, there is an incentive to
actually book a bigger profit or to
price this laptop at $800. In other
words, the value of the laptop
ultimately shipped overseas would rise.
And this trend, multiplied over
thousands of price transfers could be
inflating China's trade surplus.
REDUCTIONS AHEAD?. We ran the numbers to
try and work out the likely impact of
mis-invoicing and transfer pricing and
were surprised by the results. Our
numbers show that the China's trade
surplus could have been as small as $35
billion in 2005. Trade could have
disguised some $67 billion of non-trade
capital inflows. We made a long list of
assumptions to get to this number, and
we are not claiming that it is
absolutely accurate. But it does give a
hint as to the potential scale of these
foreign currency inflows.
So, say we are right. Then there are two
big implications for China's
policymakers. First, China's booming
trade surplus does not necessarily
indicate new and real pressures for yuan
appreciation. This is another reason for
cautious currency appreciation. As soon
as the yuan reaches a point where
expectations of appreciation disappear,
China's trade surplus could suddenly be
sharply reduced. Second, Beijing has
said that it will try and bring down the
trade surplus in 2006.
There have been calls to increase the
tax rate on foreign-invested enterprises
(which concentrate in the export sector)
or to reduce the value-added tax rebate
exporters enjoy. But if we are right,
then the case for such policies is weak.
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