China’s Flawed Balance-of-Payments Position

BEIJING – The balance-of-payments figures that China’s State Administration of Foreign Exchange (SAFE) released in April should have triggered serious concern, if not alarm. The data adjusted China’s investment-income deficit for 2011 from $26.8 billion to $85.3 billion – a massive revision that casts doubt on the reliability of China’s balance-of-payments statistics and exposes a flaw in the economy’s growth path. But few people seem to care.

According to SAFE, as of February 2012, China had accumulated $4.7 trillion in foreign assets through purchases of United States government securities and other investments, and more than $2.9 trillion in foreign liabilities through foreign direct investment (FDI) and borrowing. This puts China’s net foreign assets at roughly $1.8 trillion.

But, despite China’s position as one of the world’s largest creditors, its net investment-income balance is deeply negative. In fact, China has run investment-account deficits for six of the last nine years, with preliminary statistics suggesting a deficit of $57.4 billion in 2012.

Two factors explain this anomaly. The first is the high return on foreign investment in China. In 2008, US corporations gained a 33% return on their investments in China, while other multinationals got a 22% return. By contrast, the return on US government securities, which form the bulk of China’s foreign assets, was next to nothing.

Second, China’s foreign assets are denominated almost exclusively in US dollars, while its foreign liabilities are denominated mostly in renminbi. As a result, whenever the US dollar declines, China’s net international-investment position (the difference between its external financial assets and liabilities) deteriorates – and so does its investment-income balance. China’s drive for renminbi internationalization so far has made the balance-sheet structure even more unfavorable.

According to the economist Geoffrey Crowther, a country’s balance-of-payments position evolves in six stages, with the key variable being net assets – that is, the country’s net international-investment position. In the first three stages, the country is a net borrower with a deficit on the investment-income account. As an “immature debtor-borrower,” its trade balance and current account are also in deficit; as a “mature debtor-borrower,” its trade balance enters surplus; and, as a “debtor-repayer,” its current account moves to surplus.

In the later stages, the country becomes a net creditor, running an investment-income surplus. As an “immature creditor-lender,” the trade balance and current account are in surplus as well; as a “mature creditor-lender,” the trade balance returns to deficit; finally, as a “creditor-borrower,” the country’s current account swings into deficit. A country in the later stages of development can use investment income from its past accumulation of net foreign assets to compensate for the decline in citizens’ incomes due to aging and other changes.

China breaks Crowther’s mold. Given that it has been running an investment-income deficit, a trade surplus, and current-account surplus, it seems that it should be classified as a “debtor-repayer.” But China is a net creditor. If China runs an investment-income deficit with net assets of almost $2 trillion, how will it make the transition to an investment-income surplus?

China’s investment-income deficit will probably persist in the foreseeable future. Its stock of foreign capital will increase steadily as foreign firms invest and reinvest in China. FDI in the country will continue to garner substantial returns, partly owing to local-government hospitality.

Meanwhile, China’s outward FDI will continue to encounter challenges, as various short- and long-term factors – from weak international demand to an aging population – cause its trade surplus to decline, diminishing its ability to export capital. China’s investment in US government securities and other sovereign debt will continue to yield extremely low returns. In fact, this investment will never be repaid in full, so a large write-off is inevitable.

The value of China’s assets as future claims on real resources has already been diluted by dollar depreciation, and calls in the US for inflating away America’s debt burden portend a further decline. Moreover, while China may have profited from the rise in government-bond prices over the last few years, prices have been inflated artificially by expansionary monetary policy in advanced countries, which implies that the bubble could burst. Whether through inflation or collapsing government-bond prices, China will suffer significant capital losses on its foreign assets, further damaging its investment-income balance.

Without fundamental changes in its economic-growth pattern, it is difficult to imagine how China can become an immature creditor-lender and a mature creditor-lender. A more likely scenario is that China will continue to have a trade surplus (though much smaller) and an investment-income deficit, mirrored by America’s trade deficit and investment-income surplus. If both countries have balanced current accounts, their balance-of-payments positions can be sustainable.

In such a scenario, the US exports to China what Ricardo Hausmann and Federico Sturzenegger have dubbed “dark matter” (unaccounted assets, such as knowledge, which US corporations export through their investments), while China exports consumer goods and services to the US. But would China be happy with this division of labor? China’s leaders should think hard about this question now – before it is too late to change the situation.