China: New US policies could hurt exports Global Economic Outlook, Q1 2017

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​In 2016, China’s exports suffered the steepest decline since the global financial crisis of 2009, and things still look grim, given concerns that the new US administration will implement protectionist policies.

The state of the economy

In December, China’s exports, measured in US dollars, declined 6.1 percent from a year earlier. For all of 2016, exports were down 7.7 percent, the second consecutive year of decline and the steepest decline since the global financial crisis of 2009. Exports to the United States and South Korea were strong, up 5.5 and 8.3 percent respectively, but exports to other locations fared poorly. Exports to the European Union were down 4.7 percent, and those to Japan were down 5.5 percent. The overall weakness in exports reflected several factors: the negative impact of an overvalued currency, the negative impact of rising Chinese labor costs relative to other countries, and relatively weak global demand.

Going forward, many observers are pessimistic about the prospects for Chinese exports. This partly reflects concerns that the new US administration will implement protectionist policies that could hurt Chinese exports. It is notable that Chinese exports to the United States continue to grow, yet possible policy shifts in the United States put such growth at risk. Meanwhile Chinese imports, measured in US dollars, were up only 3.1 percent in December versus a year earlier. This was a slower rate of growth than many analysts anticipated, and reflected weak domestic demand. In addition, much of what China imports involves inputs that are used to produce exportable goods. Thus export weakness fuels import weakness.

Avoiding a bubble

It appears that China’s effort to stem the rise in house prices is working. In November, house prices in the country’s four big coastal cities (Beijing, Shanghai, Guangzhou, and Shenzhen) increased only 0.1 percent from the previous month. This follows many months when prices rose 3.0–4.0 percent per month. In addition, in the first half of December, the volume of residential floor space sold fell 17.0 percent from a year earlier.

Among the measures implemented by many local governments are restrictions on purchases of second homes, requirements for larger down payments, and restrictions on borrowing for the purpose of purchasing land. The government in Beijing recently defended these actions, saying, “Houses are for living in, not for speculating with.”1

Indeed, much of the frothy behavior of house prices in recent years has been due to excessive speculative activity on the part of Chinese investors.

Indeed, much of the frothy behavior of house prices in recent years has been due to excessive speculative activity on the part of Chinese investors. In the past several years, the government has gone back and forth on this issue, stimulating housing when the economy weakened, and restricting housing when prices threatened a speculative bubble and when debt appeared to grow too fast. We are now in the former phase, and many analysts expect housing market activity to decline in the coming months. Yet, if this leads to a slowdown in the economy, the government could reverse course. On the other hand, some analysts expect that the government will accelerate the pace of infrastructure investment in order to offset a deceleration in housing.

Currency concerns

The Chinese authorities are concerned about the outflow of capital from China, which is putting downward pressure on the value of the currency. As such, they have instituted some capital controls meant to discourage Chinese companies from acquiring overseas assets. Yet the reality is that bank lending accounts for a much larger share of capital outflows than direct investment. In fact, in the first nine months of 2016, outbound direct foreign investment was $78 billion, while the outflow from bank lending and securities investment was $301 billion. A leading economist, Brad Setser, says that “several hundred billion in outflows are simply associated with repayment of existing loans.”2 Interestingly, foreign bank lending to Chinese nationals has actually decreased in the past two years. Yet the repayment of the massive loans taken prior to that continues to generate substantial outflows of capital. Also, there is no method of capital control that the government could use to stem that outflow. Thus downward pressure on the currency is likely to continue.

This means that the central bank will either continue selling foreign currency reserves in order to stabilize the currency, or it will simply allow the currency to fall in value—something many analysts now expect. Yet there will clearly be a political cost to allowing depreciation. The incoming Donald Trump administration in the United States is already complaining about the value of the renminbi. A cheaper renminbi could lead to further calls for trade restrictions. Moreover, a cheaper renminbi will mean that Chinese companies with dollar-denominated debts will have greater difficulty servicing them.

For many years, when capital inflows into China put upward pressure on the renminbi, the Chinese central bank fought currency appreciation by furiously purchasing foreign currency reserves, many of which were held in the form of US Treasury securities. The question has often arisen as to whether there is a risk that China might wreak havoc with US financial markets by dumping large amounts of US Treasury bonds. The answer is that the Chinese are unlikely to do this, as they would then suffer a capital loss.

Moreover, Chinese holdings, large as they are, do not represent a systemic risk. Even a large sale by the Chinese would not be sufficient to move the market substantially. Indeed, it turns out that China has actually been selling US Treasuries in large amounts. Although it may be wrong to say that they would never do this, it is correct to say that the impact would be muted. For the past three years, capital outflows from China have put downward pressure on the currency. In order to prevent the currency from dropping sharply in value, the central bank has been furiously selling reserves, including its stash of Treasuries. The result is that, today, China is no longer the largest non-US holder of US Treasuries. That status now belongs to Japan, which had held that status prior to 2008. Although US bond yields have risen since the election, they were historically low for most of 2016, a period during which China sold Treasuries at a rapid pace. Thus Chinese sales do not appear to have made any difference. For China, the necessity of avoiding a sharp depreciation of the renminbi suggests that such sales are likely to continue. And now that the US Federal Reserve has begun interest rate normalization, the downward pressure on the renminbi is likely to increase.

Market status

When China joined the World Trade Organization (WTO) 15 years ago, it was not given market economy status because of the heavy involvement of the Chinese government in the economy. However, the United States and the European Union had made a commitment that, eventually, China would be given such status. Market economy status would imply that the prices of Chinese goods are determined by market forces rather than by government fiat. As such, it would make it more difficult for China’s trading partners to impose anti-dumping duties on Chinese imports. Not having achieved this status, China is launching a case at the WTO that such status should now be granted. China’s case rests on a clause in its accession agreement with the WTO indicating that there would be an automatic shift to market status no later than 15 years after accession. If the WTO rules in China’s favor, the United States and the European Union will have no choice but to comply. So far, however, both have resisted China’s demands for market economy status. They have pointed to China’s alleged dumping of cheap steel on the global market, fueled by excessive and unprofitable production by state-run companies in China. They claim that a large part of China’s economy is not yet characterized by market status.

Market economy status would imply that the prices of Chinese goods are determined by market forces rather than by government fiat. As such, it would make it more difficult for China’s trading partners to impose anti-dumping duties on Chinese imports.

The incoming Trump administration is expected to take a relatively protectionist stand on trade with China. It is not yet clear, however, what this will mean in terms of official US resistance to China’s desire for market economy status. It is possible that the United States and the European Union will seek concessions from China in exchange for granting such status. If, instead, the WTO must rule on China’s claim, the process could take up to two years.