China's Root Problem is Export Competitiveness

Bear with me while I explain this, because the headline is not meant to be cute, but rather to draw your attention to a fundamental truth. Behind everything else, China's problem is its expensive and sustained failure in exporting to Western markets – a problem which was surfacing before the global financial crisis, but which has been greatly exacerbated by it, and which won't automatically be solved by the West’s recovery.

Though this problem is absolutely unseen in the West, and barely acknowledged in China itself, it is nonetheless demonstrably true: after overwhelming historic success China’s exogenous growth model is exhausted. It is this, as much as anything else, which makes a change in China’s fundamental growth model both inevitable and urgent. Left unchecked, the current model will eventually end in uncontainable financial stress (though not, so far as I can calculate, during the current cycle).

We’ll start with the numbers. We get hints of an underlying deterioration simply from looking at the rise and then stagnation in China's exports as a percentage of NE Asia's total exports. In the early 1990s, China accounted for barely 15% of NE Asia’s total exports (China, Japan, Korea Taiwan), rising to around 25% during 1998-2001. However, it was between 2001 and 2008 that China emerged as the modern-day exporting giant we take for granted. By 2008 China accounted for more than half of NE Asia’s total exports. Since then the proportion has stagnated, but of itself, this proves little, since one of NE Asia’s prime export markets has become. . . . China itself. And that’s one market China’s exporters can’t be recorded as triumphing in. So is this stagnation of China’s market share as trivial and inevitable.

No: there more to it than that. The seemingly inexorable rise in China’s export market share hasn’t just halted as a proportion of NE Asia’s total exports: China’s  share of NE Asia’s exports to Western markets (N America and Europe) has also stalled. Between 2000 and 2009, on average China’s market share of NE Asia’s exports to North America gained 3.9 percentage points a year; to Europe the gain averaged 4.1 pps a year, and by 2008 China was responsible for 54% of NE Asia’s exports to N America and 57% of the region’s exports to the EU.

However, it came to a grinding halt in2008/09, and in the 27 months between April  2009 and July 2011, China gained only 2.8pps of NE Asia’s exports to N America, and only 3.9pps of market share to Europe. And over a quarter of that was made in the months after Japan’s March 11 catastrophes, which temporarily eliminated Japan as a competitor.

Now, one response to this is: ‘Well, China’s still gaining market share – but just at a slower pace.’ But once again, this radically understates the problem. For the corollary to China’s rising share of NE Asia export trade is the build-up of capital stock which has accompanied the industrial relocation China’s rise.   This is something we can estimate, by tracking changes in the estimated size of capital stock in NE Asia’s economies. I do this simply by depreciating all (US$-denominated) gross fixed capital stock over 10 years.  What we discover is not immediately startling: whilst China’s share of NE Asia’s exports to Western markets was rising from 15.5% to 51.6% between 1996 and 2010, its share of NE Asia’s capital stock rose from 12.1% to 53.8%.

But look more carefully, and one can see that since 2005-2006, the slope for China’s proportion of capital stock has been rising rather faster than its market share of exports.  What this tells us is that as far as exports are concerned,  China’s capex effort –  which is, after all, the key to its exogenous growth model – has hit diminishing returns as far as export markets are concerned.

And we can measure this by expressing China’s change in share of NE Asian capital stock as a multiple (or fraction) of the change in its market share of NE Asia’s exports to the West. The chart below does exactly that.  What it shows is that between around 2000 and 2005, a one percentage point gain in share of NE Asia’s capital stock was regularly associated with a gain in China’s share of NE Asia’s exports to the West of around two percentage points.   However, by 2006 the gain had slipped merely to one: ie, China was no longer gaining export market share disproportionately to its capital inputs. This persisted into 2007 before collapsing completely in 2008, 2009 and 2010 (and – without doubt, in 2011 as well).   By 2010, a one percentage point gain in China’s share of NE Asia’s capital stock was associated with a gain of just 0.22 percentage points in China’s share of NE Asia’s exports to the West.

Quite simply, China’s exporters have never really recovered from the disasters of 2009. This is observable even in data for the first half of 2011,  when China’s market position was drastically enhanced by the March 11 catastrophes which enveloped Japan.

The problem is not that China can’t gain market share, but rather that to do so has become extravagantly expensive.  China can compete against the rest of NE Asia, but it’s an ever-more costly exercise.

(Incidentally, it's easy to misinterpret the chart as saying that for every dollar of China's capital investment buys less than a dollar worth of exports to the West. But of course, the proportion of investment spending in China (48.7% of GDP) is almost double the proportion of export-earnings (28.5% of GDP), so it is nearer the truth to say that two dollars of capital spending no longer buys one dollar of export-earnings from the West. Or, since 2008, that four dollars' worth of capex no longer buys a single extra dollar of export-earnings from the West.)

What we see is that China’s response to a deterioration in its underlying labour cost advantage and an ever-deteriorating terms of trade has been ever-increasing capital investment of diminishing returns. In the end, this can, must, will, and is leading to a steady erosion of net cash flow from the corporate sector, and a deterioration of net cashflow into the banking system. It’s a slow retreat from a position of great advantage, and with China’s private sector savings surplus having diminished from double digits in 2007/08 to around 4.6% now, it’s not one which is likely to turn critical in the next year or 18 months.  But unless there’s a fundamental change in China’s growth strategies, it will happen.

And in the meantime, the bills for that over-investment are piling up everywhere. So to repeat: China’s root problem is one of export competitiveness, and its economic response to losing it.