What China's Surging Trade Surplus Means

• China's Private Sector Savings Surplus is On the Rise Again
• This Will Slow Domestic Demand, Probably by Around 1.5% of GDP This Year
• Bad News for Commodity-Producers
• But Rising PSSS Means Recovering Cashflows into Banks and Financial System
• Even as NPLs Rise, Financial Crisis Mysteriously Retreats
• Problem: Transition to Domestic Demand-led Growth Recedes From View  

China's US$31.7bn June trade surplus confirms what we had already suspected – that China's private sector savings surplus (PSSS) is no longer falling. The surplus, which was 42% bigger than in June 11, and was the largest since July 11, was the product of a a 8.6% mom 1.3 SD sequential collapse of imports, rather than any surge in exports (they fell 0.5% mom). Whilst 1Q12's trade surplus of US$1.15bn was only fractionally better than the US$706mn deficit in 1Q11, the US$68.85bn surplus of 2Q12 is 47.3% bigger than that recorded in 2Q11.

The trade balance is not the only component needed to calculate the private sector savings surplus: we need also the current account and the fiscal position (ie, public sector saving/dissaving). But since we have government revenues and spending data up until May, and the trade balance is by far the biggest component of the current account, we can be fairly certain of the trend.

I estimate that the 2Q12 current account will show a surplus of about US$82.9bn, which is likely to be around 4.4% of a nominal GDP which itself is likely to grow by around 10.7% yoy. China's balance of payments is intensely seasonal, and that 4.4% compares with 3.5% in the same period last year, and lifts the 12ma to 2.8% from the 2.6% up to 1Q12.

At the same time, the fiscal numbers up to May suggest government revenues will rise around 13.1% yoy in 2Q (vs 14.7% in 1Q), whilst expenditure is likely to grow 11.4% yoy (vs 17% in 1Q). If so, China's government will show a surplus of Rmb 538bn in 2Q12, compared with Rmb 437bn in 2Q11.

A larger government surplus, of course, will mean that private savings surpluses account for a smaller portion of the overall current account surplus. This is particularly clear in this case – in fact expected budget surplus in 2Q is just about the same size as the expected current account surplus. As a result, the private sector remained very slightly in deficit during 2Q12, albeit at only a quarter of the deficit of 2Q11. But this is highly seasonal data, and on current trends, we shall see the savings surplus burgeon in the second half.

 The decline in the PSSS of the last two years has already been halted, and 2H will see it sharply reversed.

This has consequences for China's economy and for its banking system. For the economy, it is fairly simple: any retreat in the surplus savings made by China's private sector represents a rise in the proportion of income consumed or invested in the domestic economy. During 2009 that added an amount equivalent to 1.3% of GDP to Chinese domestic demand; in 2010 it added an amount equivalent to 1.9%, and last year it added 3%. This year, if the trends of the first half persist, the rising PSSS will probably subtract an amount equivalent to around 1.5% of GDP from domestic demand.

That doesn't mean that GDP will shrink by a similar amount, since the loss to domestic demand will be partly recouped by net exports (as we see). But it does mean a slower rate of demand growth for those commodities and services fuelling China's domestic economy. We also saw this in June's trade numbers, which conspicuously featured some of the weakest imports of industrial commodities seen since variously December (crude oil) to last August (copper).

In the short term, it will also underline the extraordinary difficulty of weaning an economy off an exogenous growth model (financial repression, massive investment, exporting of the resulting surplus production) and onto one more powered by domestic demand.

But for China's banking  and financial systems there is a silver lining: a rising PSSS will help re-liquefy a financial system which has begun to recognized that the net inflows of deposit cash on which it relied has been drying up. This matters hugely: when the banks enjoy net positive cashflow, they are not forced by sheer commercial necessity to come to terms with any assets on their books which are wrongly-priced. (On a related issue, non-performing loans are easier to rollover or extend). It is only when banks are forced to sell assets in order to generate a positive cashflow to substitute for the suddenly insufficient inflow of deposits that they discover the real value of those assets. It is no coincidence that Chinese bank npls are rising just as banks'  net cash inflow has begun to dry.  Conversely, as the PSSS once again begins to rise, we can expect issues such as those local government financing vehicle loans mysteriously to fade into the background.

In other words, the chances of a slowdown in the domestic economy rise (bad luck, commodity producers), but the 'crash landing' scenario retreats.