In what may represent a historic change to China's mercantilist economy, recently we noted that in the first quarter of 2018, China had recorded its first current account deficit this century.
Now, in a note from Deutsche Bank that explains the bank's justification to revise its USDCNH forecast higher (now expecting the Yuan to drop to 7.40 against the dollar versus 6.90 previously), the bank picks up on this observation and as chief China economist Zhiwei Zhang writes, China had a current account deficit of US$ 34bn in Q1, the first quarterly current account deficit since 2001 Q2.
He then goes on to preview that the current account balance for Q2 will be released on Aug 6, and while the monthly balance of payments data suggest that China likely has a surplus in Q2, it will be much smaller than the past years.
"Consequently the current account balance in H1 has likely turned into a deficit", Deutsche Bank predicts.
Here are the details:
the monthly data release shows China’s balance of goods and service trade recorded a surplus of US$ 31 bn in Q2 after a large deficit of US$21 bn in Q1 ( Figure 1 ). Growth of goods exports slowed in H1 to 11% while import growth surged to 20%. The service trade deficit widened to US$149 bn in H1 from the five year average of US$90 bn ( Figure 2 ).
The Q2 income balance in the current account has not been released. To turn the current account in H1 into surplus the income balance needs to show a surplus of at least 3bn in Q2 which is quite unlikely, as it has been in deficit for most of the past three years ( Figure 3 ).
As a result, DB expects China’s current account balance to show a small deficit around US$15bn in H1 (a deficit of US$34bn in Q1 and a surplus of US$19bn in Q2), assuming the income balance in Q2 to be the average of past two years (- US$12bn).
It would be the first time China had a current account deficit on half year basis since China started to publish quarterly data in 1998.
Why is this important? As Zhivei explains, the decline of current account surplus is a structural trend which is driven by
- consumption upgrade due to a strong wealth effect from the booming property market, particularly in tier 3 cities
- slower growth of exports as China loses competitiveness in labor intensive products to other low income countries. The trade tension will likely put further pressure on the current account in coming years, as China tries to promote imports to avoid trade war.
He goes on to note that while the trade war has not affected China's current account visibly yet in H1, it will certainly reinforce the downward pressure in H2 and 2019 as pressure on exports increases, especially if Trump imposes more tariffs than are already in place (which he will). Adding to the downward pressure, China is trying to promote imports to mitigate the trade tension. As a result, "the trade surplus will likely shrink in the next few years."
Extrapolating a few years out, DB forecasts that China's current account balance will drop to 0.6%, 0.3% and 0% of GDP in 2018, 2019 and 2020 (2017: 1.3%).
The implications of China going from current account surplus to deficit are profound: it would mean greater reliance on foreign funding, a more open capital account, a weaker CNY and deeper and less manipulated capital markets; in a nutshell it would mean that China is becoming a new America, and the Yuan would need to increasingly be seen as a legitimate reserve currency to fund the deficit. Of course, it would also mean less "ability" to massage the Chinese economy.
And as a result of the resulting downward pressure on the currency, DB revises its USDCNY forecast to 6.95 and 7.40 by the end of 2018 and 2019. However there is a twist:
We expected RMB to weaken but the pace of depreciation has turned out to be faster than we expected. The PBoC may step in to smoothen the path of depreciation but we doubt they will intervene heavily to reverse the trend of depreciation.
Actually, judging by today's action, they are doing everything in their power to accelerate it.
Finally, there are two more reasons why the Yuan is set to keep sliding.
First, the capital outflows seem to be picking up in June after being stable for most of H1.
Second, interest rates are once again edging lower as monetary policy has aggressively loosened in recent weeks.
Of the two, the first issue is by far more the most critical variable when it comes to China's economy, as Eric Peters recently explained, which is why DB notes that it expects China's capital controls to be tightened in the next few years to maintain a loose liquidity condition in China without even faster depreciation.