Back in August 2 we reported of a historic event for China's economy: for the first time in its modern history, China's current account balance for the first half of the year had turned into a deficit. And while the full year amount was likely set to revert back to a modest surplus, it was only a matter of time before one of the most unique features of China's economy - its chronic current account surplus - was gone for good.
Then back in November, UBS wrote that the upcoming loss of China's current account cushion, softening domestic activity, and upcoming tariffs mean that "for the first time in 25 years, China would have to make a choice between external stability and growth."
Now it is the Wall Street's Journal's turn to bring attention to this topic, calling it a "tectonic shift" in China's economy, which has largely gone unnoticed by investors, and which is "quietly beginning to upend the global financial system."
A key driver behind China's declining current account is that after having long been the world’s heavyweight saver and a huge buyer of foreign assets like Treasurys, the world's most populous nation is now a big spender, and in early 2018, China got more of its growth from consumption than the U.S., the global king of consumer spending where some 70% of economic growth is due to consumer spending. And as China's increasingly wealthy population spends more at home and abroad, its total trade surplus with the rest of the world has shriveled to a fraction of its former size.
In other words, China is rapidly becoming the next US.
This transformation of China into a consumption-driven economy has enormous implications for global capital markets, and impacts everyone from retirees investing in U.S. Treasurys to fund managers investing in emerging markets like Indonesia or India. It could, the WSJ notes, also eventually help ease some of the frictions between the U.S. and China.
To be sure, China is still an export powerhouse - after all, it is China's massive trade surplus with the US that is arguably the reason for the ongoing trade war between the US and China. However, it is China's declining trade balance with the rest of the world that is of bigger concern in this context. As a reference, China's trade surplus has shrunk by a third in just three years: in 2015, the country exported around $150 billion worth of goods more than it imported each quarter. In the third quarter of 2018, the goods trade surplus was just $100 billion.
Furthermore, as China's citizens have become wealthier, they are consuming more too instead of saving. One place where this consumption is evident on a global scale is in the form of tourism; indeed China's net spending on foreign services such as tourism surged from $50 billion to more than $80 billion over the same 2015-2018 period. While some part of that is travelers laundering money abroad to evade China’s strict controls on overseas investment, the reality is that anyone who has been in the world’s major cities in the past few years has witnessed the tidal wave of Chinese tourist spending (and its recent drop - just ask Tiffany's).
And while all the those wealthy tourists have been a windfall for tour operators, and retailers who cater to an ultra wealthy Chinese clientele, their spending sprees mean China has less left over for other assets: such as U.S. Treasurys. This has a direct impact on such key aspects of China's economy such as its exchange rate: as a result of slowing savings, Beijing is no longer buying dollars to keep mushrooming trade earnings from pushing up the yuan, but rather the opposite. Chinese holdings of US Treasurys peaked at $1.3 trillion in 2013 and have since declined to $1.1 trillion, a trend that will only accelerate in 2019 if new U.S. tariffs further reduce Chinese exports.
Naturally, a drop in Chinese capital flowing into U.S. government bonds raises many problematic issues, especially at a time when the US deficit is expected to hit $1 trillion as soon as this year and keep rising; and while the lack of China as a net buyer may not seem like a big deal now with yields falling as investors flee wobbly equity markets, it will weigh on Treasury prices over the long run especially if US domestic purchasers who have largely picked up the slack from China back away. While total foreign Treasury holdings have been essentially flat since 2014, overall Treasury debt is up about 20% since then. The risk is that lower demand for its bonds means the U.S. government has to pay more to borrow, forcing interest rates sharply higher.
But as the WSJ notes, before the US is eventually impacted, a more immediate impact has been a huge hit to emerging markets. As China consumes more, there is less money available for investment, and - taking another page of the US playbook - Beijing has been trying to attract more foreign capital to fill in the gap. As a result, emerging markets suffered last year not only because of the rising dollar, but because China is attracting unprecedented inflows to its stock and bond markets.
As the chart below shows, according to the IIF, China captured a whopping 75% of nonresident portfolio investment in emerging markets in 2018 and will absorb around 70% in 2019, up from just 28% in 2017. China's Americanization has had a staggering impact on recent capital flows: in the second quarter alone, China attracted $61 billion of net portfolio investment inflows—triple the quarterly levels it was drawing in as recently as 2014. All other emerging markets, meanwhile, saw a 2018 full-year net outflow of $45 billion according to IIF data. One implication: Even if the dollar weakens in 2019, many emerging economies could still struggle, because they are now competing with China for foreign investment capital.
Picking up on this theme, Bloomberg notes that following the massive exodus of Chinese capital in 2015, Beijing policymakers decided that in order to alleviate pressures on their currency, they would attract foreign cash—and boost demand for the yuan—by opening the doors to fixed income investors under the assumption that big overseas funds are always looking for ways to diversify and would likely want some exposure to China’s bond market, the third-largest in the world.
It worked... for a while. Money poured in, and inflows accelerated after China set up a channel called Bond Connect for foreigners to trade through Hong Kong in July 2017. But overseas funds started pulling money out in late 2018. That's when U.S.-based investors trimmed their participation in the country’s dollar-denominated sovereign bond sale in October, accounting for only 2% of the five-year notes China issued, down from 20% in 2017. Then, in November, China’s biggest bank, Industrial & Commercial Bank of China Ltd., canceled a dollar bond sale in the U.S.
To be sure, China’s policymakers are urgently trying to attract bond investors, and Goldman Sachs anticipates a fresh campaign by China to promote investment in its assets. A key milestone will come in April when China debt will start to be included in the Bloomberg Barclays Global Aggregate Index, assuming certain criteria for accessibility and transparency are met.
It is unclear, however, if buyers will emerge: after all they may have just as attractively yield US bonds competing for the same capital. Indeed, the unhedged yield differential between US and China bonds has collapsed to almost nothing.
“Capital inflows, especially those into the bond market, will be very crucial for China’s balance of payments, as the current account will deteriorate further amid the trade war and the restructuring of the economy,” said Becky Liu at Standard Chartered.
Which goes back full circle to what we said about China's shrinking current account: with China’s trade surplus subsiding, and likely to become a current account deficit before long, if China’s bond market receives waves of overseas cash, that will help finance the deficits without running up a dangerous amount of debt in foreign currency. Then again, that's precisely the same boat that the US finds itself in as well.
Curiously, just like the US needs hundreds of billions in outside capital, so does China. Estimates on inflows in coming years vary from about $760 billion over the long term at Morgan Stanley to Goldman’s $1 trillion by the end of 2022 to $3 trillion through 2020 at UBS.
While the money is flowing for now, whether or not that continues will depend on the outcome of the trade war. Jason Pang, a fixed income portfolio manager at JPMorgan Asset Management in Hong Kong, said he has been boosting China holdings in recent months. But "whether we will add more," he said "depends on the trade war."
Ironically, as China's funding needs grow to approach those of the US, it is giving Washington further leverage in the ongoing trade war. In fact, it may be one reason for optimism about a U.S.-China trade deal. While China may not budge on U.S. demands to cease supporting critical technology industries like microchips and robotics, it urgently needs more foreign cash — most obviously for industries like health care where prices are too high and service often horrendous.
The WSJ's conclusion: "U.S. investors this week were focused on the surprising news that Apple’s iPhone sales were falling short of expectations in China, and fretting about what that might augur for the months to come. But over time, what will matter more to global markets is the big rise in Chinese consumer demand, the big fall in Chinese savings and the big increase in China’s need for foreign capital."