Financing China’s Capital Requirements in the 2020s

By Ichiro Suzuki

It has been long expected that China would shift the gear of its economic growth to be less export-dependent and be more domestic demand-driven. Household sector consumption-driven to be specific about domestic demand, as roaring growth of public sector investments in infrastructure has seen its best days. High speed railways and high ways are already connecting most large cities. They are yet to be extended to rural China, but only with smaller marginal contribution to economic growth. Infrastructure investments are experiencing diminishing ability of driving the economy. It has to be household consumption that has been long suppressed, having been forced to take a backseat to infrastructure.

The external sector has also been witnessing its contribution to growth falling throughout the 2010s. At the height of it, around the time of the Beijing Olympics in 2008, current account surplus rose to double digit figures compared to the size of the Chinese economy. By the end of the 2010s, the current account was largely balanced. This is not because of lost competitiveness of the export sector but of robust spending by Chinese tourists on overseas trips. That said, China can export only so much as it is the second largest economy that is often projected to overtake the U.S. one day. There is a limit on what consumers in the overseas markets are capable of spending on Chinese goods. The Sino -American tech Cold War is casting clouds on China’s exports, too. 

COVID-19 is keeping Chinese tourists home since a year ago, dramatically improving the current account. However, such improvements could be rather temporary. Either humans overcome the pandemic even if it might take longer than hoped, or China’s middle class and above displays their spending power at home, or both. President Xi considers the latter as his policy goal. A consumption boom sucks in imports, making a dent on the trade account. On top of it, aging population exerts a downward pressure on household savings, as retired people draw down from their savings they accumulated during their working years, especially in a land of insufficient safety nets. Lower savings rates are negative for exports. 

While modest current account deficits are not necessarily bad, falling surpluses do presents a problem for the Chinese economy. Current account surpluses have been providing a source of funds to the economy along with household sector savings. When the current account falls into deficit in the future, the Chinese economy needs to find a new source to fund economic activity, especially at a time when householder savings are falling as the population ages. 

Japan, on the other hand, is a step ahead of China in terms of aging population and its household savings rate is rather low, negative sometimes. Despite it, Japan runs very steady and persistent current account surpluses year after year. Its trade account has been largely balanced for years, and is sometimes in deficit depending on the price of crude oil, the largest import item. However, investment income from overseas assets have been strongly underpinning the current account, generating surpluses that amount to over 2% of GDP. They are interest payments from U.S. Treasury and other foreign fixed income securities, or they can be dividends from Corporate Japan’s overseas subsidiaries, i.e. Toyota Motor North America, Sony America, to their headquarters in Japan. China has not come to this point yet. It is one thing that China money makes headlines on its robust outflows into overseas assets, but it is entirely another whether such investments are generating returns or not. Corporate China is still new in potentially lucrative, though fiercely competitive, developed markets in the West. It takes years, decades quite possibly, to build successful businesses there. It takes very long-term commitments. On the other hand, Chinese money’s acquisition spree has died down the last few years. Besides, Chinese businesses’ presence has been carefully scrutinized in the developed world lately. It is also doubtful massive infrastructure investments in the Belt & Road Initiative (BRI) aid recipient countries are generating returns. Those investments have been often made on political and strategic grounds rather than genuine return-oriented motivations. These countries in general have not been known their prowess to manage their economy, in part due to persistent political instability. Worse, they’ve been suffering from weak commodity prices in recent years, on which many of them are immensely dependent. China does hold over a trillion dollar in U.S. Treasury securities, often competing Japan for the spot of top foreign lender. Since the Chinese economy is almost three times the size of Japan, however, their interest payments’ effect on the current account is cut to a third, in relation to the size of the economy. While China has turned hostile to it lately, foreign capital has long made great contribution to China’s development since the days of Deng Xiaoping. That means money is repatriated out of China in the form of dividends to the domicile country of foreign capital, making a polar opposite effect from Japan on the current account. 

Foreign money has to come into China to fund the country’s growth that continues to be higher than that in the developed world. $140 billion would be required to fund a current account deficit at 1% of today’s Chinese economy, and $280 billion for 2%. Such deficits are considered modest by the standards of international finance. The Stability and Growth Pact on which Europe’s single currency is based allows a member country to run current account deficits up to 3% of GDP. While such deficits are modest in relation to the size of the economy, they are still large amount due to the sheer size of the Chinese economy.

In a world awash of liquidity, there is no shortage of funds that are looking for opportunities in China. Its growing bond market, estimated at $14 trillion in size, should look very attractive to foreign investors. It is about the same size with Japan’s while offering much higher yields. China’s ten-year government bonds yield over 3% as opposed to absolutely nothing for Japanese government bonds. That said, China had better not take such inflows for granted. Returns from Chinese stock markets have not been as great as generally believed. Growing shadows of the Communist Party not only on SOEs but also on genuinely private corporations does not bode well for future returns from Chinese equity markets. The renminbi is still far from free-float more than four years after China’s coveted entry into the IMF’s special drawing rights (SDR). Liberalization of the RMB is keenly needed to entice foreign capital but doing so is a double edged sword. It would most likely spark an exodus of Chinese retail money that has been stuck in the domestic financial markets and is looking for better opportunities outside the country. 

Mr. Suzuki is a retired banking executive based in Tokyo, Japan.