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There has long been a basic tension in the IMF’s analysis of China.
- The Fund thinks China’s external accounts are now fairly balanced.
- The Fund doesn’t think the policies that have brought China’s current account surplus down are sustainable—it wants less credit growth (see paragraph 23 of the staff report, "The recent credit acceleration should be curtailed to prevent an increase in credit growth in 2019, and further deceleration should occur in 2020") and a lot of fiscal consolidation (7.5 pp of GDP over ten years; "Reducing the augmented deficit by about ¾ percent of GDP a year over ten years would stabilize debt while keeping the growth impact manageable").
The Fund opposed China’s 15-16 stimulus; it wanted China to accept a slower pace of growth instead. Yet without that stimulus, the recovery in global trade in 2017 would have been much weaker and China’s current account wouldn’t have moved close to balance.*
And the IMF’s latest assessment of China’s economy essentially reads as a warning against easing too much in the face of Trump’s tariffs (see paragraph 23, which advises "avoid additional stimulus and excessive credit growth"). Though, to be fair, it was written for a baseline that is now several rounds of tariffs ago…
China actually seems to have followed the Fund’s advice—it hasn’t taken the regulatory pressure off the shadow banking system, and the fiscal loosening has been on the modest side. The Fund thinks China’s 2019 fiscal deficit—counting local government’s investment vehicles—will rise by 1.5 pp of China’s GDP. But since China’s fiscal stimulus was poorly targeted, it is only expected to provide a percentage point support for China’s growth. (I very much agree that the stimulus was poorly designed, with far too much emphasis on tax cuts).
The problem? With a pull back in credit from the shadow banks and a more modest easing than in 16 and 17, China’s current account surplus is heading back up.**
Nominal manufacturing imports are down 8 percent y/y in the first half of 2019, and real imports are also shrinking (according to the UBS China team). If China’s economy was judged solely on the basis of the trade data (even setting aside trade with the United States), you would think China’s economy is basically in something akin to a recession and that it needs more, not less, stimulus to stabilize activity.
China also has subdued inflation and low real interest rates—on the standard indicators, it doesn’t obviously seem to be overheating.
Yet the Fund is advocating—over time—a 7.5 pp of GDP fiscal consolidation together with a slowdown in the growth of private leverage. That’s a policy prescription, in my view, for a return to large Chinese external surpluses. The Fund’s workhorse current account model indicates that a percentage point of fiscal consolidation normally reduces the current account deficit/adds to the surplus by about a third of a point of GDP. A 7.5 pp fiscal consolidation consequently would normally be expected to generate roughly a 2.5 pp of GDP swing in the external imbalance.
After the expansion of the current account surplus in the first half of 2019, China’s surplus is now between 1.5 and 2 pp of GDP (accounting for the tourism mismeasurement, see the New York Fed’s Liberty Street blog). The Fund’s fiscal recommendation—if fully implemented—would generate a current account surplus of over 4 percent of GDP. That’s quite large in dollar terms—$800 billion or more, given the projected future size of China’s economy (the Fund does want the fiscal adjustment to be gradual/the Fund has China’s 2024 GDP at around $20 trillion).
China is of course a hard case. Only Singapore has a comparably high level of national savings.*** And a city state with a $300 billion economy, can get away with a current account surplus of 15-20 percent of its GDP while a $13-14 trillion economy, cannot. China’s national savings rate of over 40 percent of its GDP is basically too large both for China and for the world.
That’s why a fiscal deficit that the Fund considers wildly unsustainable—the Fund frames its recommended 0.75 pp a year fiscal consolidation over ten years as the moderate option, as it is less draconian than a 1.5 pp of GDP a year consolidation over 5 years that otherwise would be called for to stabilize the debt dynamics—hasn’t come all that close to generating a current account deficit.
And that’s also why the Fund is in a difficult position.
The set of policies that have brought China’s external surplus down doesn’t pass the Fund’s fiscal sustainability tests.****
And the policies that would stabilize China’s fiscal position would, based on the Fund’s own modelling, put China’s external accounts back out of balance.*****
Now the Fund’s advice isn’t that important a driver of Chinese policy. The Fund expects China to run larger fiscal deficits than the Fund thinks are optimal. And it now looks like those fiscal deficits won’t be enough to keep China’s current account in balance—I don’t think the recent rise in China’s external surplus has gotten the attention it deserves. China’s 2019 external surplus is likely to be around $200 billion (it was $185 billion over the last four quarters of data).
But there is a bigger point: so long as China’s national savings rate is 43-44 percent of its GDP, the potential for a much larger (and globally more problematic) Chinese current account surplus remains. One way of showing this is to think of China’s annual savings in dollars: it now approaches $6 trillion, up from around $2 trillion before the crisis. The raw material for a very large surplus is there.
Safely bringing China’s fiscal deficit down—in my view—requires very aggressive reforms (much stronger social insurance, a much more progressive tax system) to bring the savings rate down. And that point, it seems to me, got a bit lost in the Fund’s analysis this year.******
Or, put differently, the Fund sort of glided over the global consequences of its preferred fiscal course for China…
And for that matter, for the global consequences of the sum of its national fiscal recommendations. A three percent of GDP global fiscal consolidation would be a recipe for keeping the main global interest rates negative forever…
* The 2018 data incidentally was heavily influenced by the q1 data point; it really reflects the relative strength of China’s economy late in 2017 and early in 2018, before China’s policy tightening started to bite.
** Contrary to the predictions of the Economist, the Wall Street Journal, and most investment bank analysts…
*** Singapore keeps it savings rate high by saving the bulk of the (undisclosed, likely because it is so big) income from the state’s massive external investments, by running ongoing budget surpluses, and by intervening in the market as needed to keep the real exchange rate from appreciating.
**** I think China could get more fiscal room with a Hamiltonian policy of having China’s central government assume more of China’s local debt. The real interest rate on central government debt is low (call it 1 percent) relative to China’s relatively rapid real growth; the intrinsic debt dynamics are more favorable. But there is no question that China’s current fiscal deficits point to an increase in its debt to GDP ratio over time. The question is how how urgent this problem is, relative to other problems.
***** As I noted in my review of the IMF’s external sector report, the Fund’s basic solution to Germany’s large external surplus is “fiscal consolidation outside Germany to reduce global demand and bring German exports down.” On its preferred (augmented fiscal deficit) measure, China should consolidate by 7.5 pp of its GDP, the United States by 3 pp of its GDP, and large European trading partners like France and Italy by 3 pp of GDP. A 1 pp of GDP fiscal expansion in Germany and the Netherlands won’t provide much of an offset. Basically, the Fund wants a very large global fiscal consolidation (see P* world in table 3 of the EBA model results) over time—which seems odd for a world that right now is marked by very low nominal rates (and negative rates on much of the world’s fixed income debt).
****** The Fund’s recommendations for bringing the savings rate down (in paragraph 46 of the staff report) are spot on. They just didn’t get any real emphasis (they weren't highlighted as key issues for example).