Cover Story: Fixing China’s Trade Imbalance Needs a Home Remedy

26 Aug 2024

Amid a prolonged real estate downturn and lukewarm domestic consumption, exports have once again emerged as a key driver of China’s economic growth. However, the surge in overseas shipments is a double-edged sword, as it has sparked retaliation among China’s trading partners concerned about protecting their own domestic industries and intensified simmering political frictions with the U.S. and Europe.

In the first half of 2024, net exports of goods and services contributed 13.9% to China’s economic growth, boosting GDP by 0.7 percentage points — a stark contrast to the negative 11.4% contribution seen in 2023, according to the National Bureau of Statistics. This export boom propelled China’s trade surplus to a record $99 billion in June, triggering fears in many countries that an influx of Chinese goods may undermine their domestic industries.

Since the second half of 2023, Europe and the United States have imposed punitive tariffs to restrict rapidly growing Chinese exports. And from the beginning of 2024, more countries have followed suit, including Brazil, Canada, India, Turkey, and Mexico.

Trade protectionism has been on the rise in recent years amid growing doubts about just how beneficial globalization is to domestic economies and heightened geopolitical tensions, including rising frictions between China and the U.S. The Covid-19 pandemic further fueled concerns about the resilience of supply chains.

Measures restricting imports taken by World Trade Organization (WTO) member states have significantly increased this year to affect $2.3 trillion worth of imports, accounting for 9.7% of the global total, marking the highest level since 2020, according to data from the trade body.

Indeed, trade imbalances are likely to be one of the most severe and significant macroeconomic issues facing the world today, said Guo Kai, director of China Finance 40 Forum and a former official at the People’s Bank of China.

As the world’s largest exporter, China has become a major target for restrictive trade measures, which beyond tariffs also include investment and export bans in the sensitive tech sector. Exports of new energy vehicles, lithium batteries, and solar cells — of which China is by far the world’s largest producer — have been prominently targeted, said the WTO.

Growing trade imbalances are complicating the external environment for the world’s second-largest economy as it grapples with a sluggish domestic recovery. China posted a lower-than-expected GDP of 4.7% in the April-to-June period due to weak domestic demand and an ailing property market, compounded by extreme weather conditions, analysts said.

According to Huang Yiping, dean of the National School of Development at Peking University, China currently has a trade surplus with about 170 countries.

“This is a problem in the long term,” said Huang.

China’s trade surplus has consistently hit new peaks since the end of the pandemic, even as the economic fallout of the virus continued to disrupt global trade. The trade surplus in goods reached a historical high of $567 billion in 2015, while the trade deficit in services has continued to expand each year, according to data from the State Administration of Foreign Exchange. In 2021 it topped that milestone to hit $636.6 billion, then surged to $837.9 billion in 2022. Despite a slight decline in 2023, by July 2024, it had already reached $518 billion, the data showed.

This reflects China’s robust manufacturing capacity and supply chain resilience, yet it also highlights longstanding structural issues in its economy — specifically, an overly heavy focus on investment at the expense of consumption and an increasing shortfall in domestic demand in recent years.

Experts have suggested that while focusing on exports, Chinese companies also need to invest more in setting up factories abroad to build a global production system.

Drawing on Japan’s experience with significant trade frictions with the U.S. in the late 1980s and 90s, when Washington sought to reduce its trade deficit by restricting imports from the East Asian nation, while further gaining access to its market, Tadaaki Kawamura, head financial attaché at the Embassy of Japan in China, suggested that China should gradually transition to exporting capital.

This shift is necessary both to enhance the external environment and to align with the current stage of China’s economic development, he said.

However, some say a more fundamental solution lies at home. China should draft policies to address both structural and cyclical challenges in its economy, said Zhang Bin, deputy director of the Institute of World Economics and Politics at the Chinese Academy of Social Sciences (CASS).

“Correcting trade imbalances involves not just eliminating the trade surplus, but rather addressing the unreasonable factors that contribute to it,” said Zhang.

Structural policies should aim to realign local government incentives towards public services and social welfare, remove barriers in the service industry to foster fair competition, and reform the financial sector to better support corporate financing and retirement insurance, said Zhang.

Additionally, Zhang emphasized the need to expand domestic demand and encourage investment to address cyclical issues, while also maintaining the flexibility of the yuan exchange rate.

Growing imbalance

Chinese products, particularly new energy vehicles (NEVs), lithium batteries, and solar cells, have increasingly become targets for punitive tariffs due to a surge in exports. Data released by the China Association of Automobile Manufacturers showed that first-half auto exports grew 30.5% year-on-year to nearly 2.8 million cars, with exports of NEVs jumping up 13.2% to 605,000 units.

Starting August 1, the U.S. raised tariffs on NEVs imported from China from 25% to 100%, while the European Union implemented duties ranging from 17.4% to 38.1% starting July 4. From July 2, Canada began a 30-day policy consultation on how to handle electric vehicle imports from China.

Unlike the historical impacts from low-value, labor-intensive products, these high-tech exports have sparked new concerns about the development of domestic industries in various countries, said Jens Eskelund, president of the EU Chamber of Commerce in China.

While cheaper products might benefit European consumers in the short term, it is crucial for Europe to maintain its industrial capabilities, especially in strategic sectors, to ensure long-term sustainability, said Eskelund.

Concerns over the impact of Chinese exports are intensifying not only in Europe and the U.S., but also in developing countries, where there is a growing fear of local industries being displaced from their markets, said Eskelund.

“It has long been assumed that China’s rise up the value chain would create a growing market for labor-intensive manufactured goods from other emerging markets,” according to a June report by the Rhodium Group. “These hopes will be dashed if Beijing cannot restart the engines of its own domestic growth and absorb more of what it currently exports.”

Faced with an influx of Chinese NEVs, the Brazilian government reinstated import tariffs in January, on a staggered schedule. Meanwhile, India and Turkey are also considering similar moves.

In April, Mexico applied import tariffs of 5% to 50% on various goods, including steel, aluminum, textiles, and plastics, with the duties lasting two years and primarily affecting shipments from India, South Korea and China.

Then in July, Malaysia began reviewing its anti-subsidy and anti-dumping regulations to combat the influx of cheap foreign goods threatening local livelihoods. And on Aug. 9, Indonesia reintroduced tariffs on textiles, targeting Chinese exports.

“Unless Beijing implements serious demand reforms, developing nations will be crowded out of manufacturing by Chinese overcapacity, leaving them dependent and without export opportunities,” said the Rhodium Group report.

Amid these growing headwinds, Chinese policymakers have repeatedly highlighted the challenges of external risks. Li Yongsha, deputy international trade negotiator of China’s Ministry of Commerce, said at an Aug. 2 press conference that the complexity and severity of the external environment are escalating, “necessitating a thorough assessment of the significant challenges within the foreign trade sector.”

Election uncertainty

A major uncertainty facing China is the upcoming U.S. presidential election in November. A potential re-election of Donald Trump, who ignited the trade war by placing tariffs of up to 25% on imports from China covering thousands of products valued at $380 billion in trade in 2018 and 2019 including solar panels, washing machines and steel, could significantly escalate tensions.

During his campaign for a second term, Trump has announced that if elected, he would impose a 10% tariff on all U.S. imports and at least a 60% tariff on Chinese goods specifically. Although analysts are skeptical that all these measures will be implemented, increasing tariffs on Chinese products is seen as the most probable policy.

Indicative of the importance of exports to the U.S. for the Chinese economy, UBS estimates that a 60% U.S. tariff could slash China’s GDP growth rate by half, cutting it by 2.5 percentage points over the subsequent 12 months.

China’s surplus in its trade in goods as a percentage of GDP has steadily increased from under 3% in 2018 and 2019 to over 4.6% by 2022 and 2023. This rise is partly due to China’s rapid recovery early in the pandemic, which allowed it to fill global supply gaps and significantly increase its share of global exports, a trend especially prominent in 2021.

Domestically, factors like a prolonged real estate downturn and sluggish consumption have dampened the economic recovery, prompting businesses to focus more on exports.

The growing trade surplus also underscores structural issues within China’s economy, according to CASS’s Zhang, with the government historically prioritizing investment over consumption and favoring heavy industry over services.

Local governments have consistently supported large-scale industrial projects with substantial tax, land, and subsidy incentives, enhancing manufacturing competitiveness. However, this approach has also led to overcapacity and fierce competition, compelling companies to alleviate excess production through exports.

Experts recommend that China utilize the WTO’s dispute resolution mechanism to manage overseas trade frictions in the short term. Gao Shanwen, chief economist at Essence Securities, suggests that China can engage the WTO to litigate and uphold the free trade system, and promote economic balance by allowing greater exchange rate flexibility.

Gao also suggested proactive trade management strategies, such as implementing export quotas and increasing export tariffs.

Given the increasing challenges in Western markets, China should pivot towards developing countries, said Peking University’s Huang. He recommends launching a Chinese “Green Marshall Plan,” which would use specific mechanisms and tools to encourage developing countries to purchase Chinese products, thereby alleviating excess capacity and aiding those countries in their transition to a sustainable economy.

This initiative would not only keep Chinese industries at the forefront globally, but also promote the internationalization of the yuan, potentially using a digital yuan for aid and policy loans.

Strategically increasing debt to fund this plan would stimulate overall demand without posing fiscal risks and would have significant international political and economic implications, said Huang.

Many scholars are urging Chinese companies to expand globally, with several already making significant strides. On July 8, BYD Co., China’s largest EV manufacturer, signed a deal to build a production facility in Turkey with an annual capacity of 150,000 vehicles.

This announcement came shortly after the Turkish government, on July 5, abandoned plans to impose an additional 40% tariff on all imported Chinese cars that was slated to come into force on July 7.

Another major Chinese company taking their manufacturing business global is leading appliance maker Hisense Group. Chairman Jia Shaoqian recently said that the company now operates 18 factories and 12 R&D centers overseas. Out of its 100,000 employees, 24,000 are international, and Hisense pays around $800 million annually in taxes abroad. As of the first five months of 2024, international markets accounted for over 45% of Hisense’s revenue.

While Beijing’s “Belt and Road” initiative launched in 2013 initially saw a Chinese global expansion led by state-owned enterprises, driven largely by policy, recently, private enterprises have taken the lead, said Kawamura.

Chinese companies in Europe mainly engage in mergers and acquisitions, relying on Chinese suppliers and importing most components, with only the final assembly and a few other processes taking place in Europe, said the EU Chamber’s Eskelund. He encouraged Chinese firms to develop local supply chains or partner with local suppliers, similar to the operations of European companies in China.

At the Caixin Summer Summit in late May, Zhang Yichen, chairman of Citic Capital, emphasized the need for Chinese financial institutions to bolster their overseas operations. He says this would not only mitigate the impact of declining domestic financial asset returns, but also facilitate the transformation of Chinese companies into multinational enterprises.

Domestic revitalization

China’s persistent trade surplus, a sign that domestic production has consistently outstripped demand, has widened in recent years, driven largely by the economy’s uneven recovery.

Exports of goods in June rose 8.6% year-on-year to $307.9 billion, the biggest percentage gain since March 2023, according to customs data. Meanwhile, imports fell 2.3% year-on-year to $208.8 billion, indicating sluggish domestic demand exacerbated by a bleak job outlook and a prolonged real estate slump.

Analysts stress the importance of expanding domestic demand through macroeconomic policies to address this trade imbalance. Zhang noted that boosting domestic demand not only increases imports, but also encourages leading companies to invest locally if it supports profitable development.

The central government has intensified policy efforts to boost domestic consumption, including providing incentives for household appliance trade-ins and business equipment upgrades, along with stronger support for the housing market.

However, structural reforms are also vital. Long-standing underinvestment in crucial areas like education, healthcare, and social security — particularly affecting migrant workers and rural residents — has significantly hindered domestic consumption, said Essence’s Gao.

A major reform plan from the recent Third Plenum promised to improve access to public services and lessen urban-rural disparities, signaling a potential relaxation of the hukou system, which has traditionally tied public service access to one’s residential registration.

If implemented effectively, these policies could significantly enhance China’s consumption and reduce systemic international payment imbalances, Gao added.

Others say that the government needs to shift its policy focus from investment to consumption, advocating for fiscal and monetary policies that support consumption growth.

Fiscal policy should prioritize increasing support for vulnerable groups, including pensions, medical subsidies, and childbirth incentives, which would boost domestic demand, promote fairness, and enhance future economic growth potential, said Lu Ting of Nomura International (Hong Kong) Ltd.

CASS’s Zhang proposed reallocating fiscal resources from business subsidies to payments for migrant workers, and funding public services and social security, which would improve the business environment and raise living standards.

A recent Politburo meeting underscored the need to focus on boosting consumption and expanding domestic demand, highlighting service consumption as a crucial lever for enhancing and upgrading consumption. The launch of new pilot measures to open up the service sector is also expected to help address trade imbalances.

Robust market competition rules and the removal of market barriers will attract more investment into the service industry, helping address the trade imbalance, said Zhang.