Why is it that some countries, such as America, run persistent trade deficits while others, such as China, run persistent trade surpluses? It’s a question we’ve been exploring this week on UnHerd.
But as well as asking ‘why?’ we should also ask ‘how?’. Goods and services have to be paid for, so how do some countries manage to buy more than they sell, year after year, decade after decade? The answer is that enough money to fill the gap flows in from other countries – for instance, in the form of loans or as asset purchases. The inflow of capital ultimately pays for the deficit in trade. The corollary is that a persistent trade surplus is balanced by a net outflow of capital to other countries. It has to be, because if were consumed instead (i.e. used to pay for imports) then, by definition, the surplus would disappear.
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Cross-border capital flows matter a lot – arguably more than the global trade that they enable (and result from). For a start they influence exchange rates and interest rates, and hence prices, jobs and wages. The sudden withdrawal of capital from a country can crash its property market, its banking system – indeed its entire economy. (From a Chinese point of view, the 1997 Asian Financial Crisis, which brought down the decades-old Suharto regime in Indonesia, is a salutary example.) An influx of capital can also be disruptive, fuelling spending booms, debt bubbles and asset inflation.
When capital flows between nations, it’s not just money that budges, but also things such as technological know-how, diplomatic influence and even national sovereignty.
In short, money makes the world go round – especially the kind of money that goes around the world.
When money flows uphill
An economic nationalist like Donald Trump should be at least as interested in the cross-border flow of capital as he is in the cross-border flow of goods and services. Certainly, some of his most influential supporters are very interested. For instance, here’s what the billionaire tech investor Peter Thiel said on the subject:1
“Capital should be flowing from the US to invest in China, and then China should have trade deficits that offset the flows. We instead live in a world in which the money is strangely flowing uphill. The US, the slower growing economy, has the trade deficits and the investments are flowing from poor people in China into the US economy. It’s completely backwards. That tells us something is very strange in terms of the trade dynamics…”
Thiel raises a perplexing issue. One would indeed expect capital to flow from mature economies with modest levels of growth to emerging economies with high levels of growth. After all, investors like to put their money where it can get the biggest return.
So why does money flow ‘uphill’ – that is against the gradient of growth – from China to the West?
Before accusing China of ‘fixing’ the global economy, western governments need to address the distortions caused by their own policies. For instance, while their overall growth rates are low compared to China’s, returns on some investments are rather more attractive. The impact of perverse housing policies on property markets and QE on stock markets, has created a speculative free-for-all. Having supplied so many get-rich-quick opportunities, we can hardly blame foreigners for filling their boots.
This suits our politicians very well. The influx of foreign cash not only provides a short term economic stimulus, it also helps keep interest rates low – always handy when there’s a perennial budget deficit to finance. Having foreigners buy up our assets requires them to buy our currency, thus pushing up its value, keeping imports cheap and inflation under control (always a worry when interest rates are low).
Obviously this is a disaster for our own exporting industries – and those parts of the country that are especially dependent on manufacturing. Meanwhile, asset bubbles suck the oxygen out of productive investment, as well as pushing house prices out of the reach of young people. All of this will come at ruinous long-term cost, but if, for the moment, it keeps the economic show on the road, our myopic rulers won’t mind.
That said, Chinese government policy is also to blame. In particular, China’s refusal to reciprocate the West’s openness to Chinese investment in western assets. As Juliet Samuel explains in her documentary, lack of reciprocity is a general theme in China’s trade relationship with the West.
How the savings of the poor changed the world
Then again, the tendency for capital to flow from developing economies to developed ones is not limited to the Chinese case. It’s pretty much a universal pattern, at least in recent decades. This is known as the Lucas Puzzle, which is named after the economist Robert Lucas, who described the phenomenon back in 1990.2 His fellow economists have been trying to figure it out ever since.
There are various theories that apply to various countries to varying extents, but what does appear to be a common factor – and, indeed, the root cause – is that people in emerging economies save a much bigger proportion of their incomes than they do in the West (and thus generate a pool of capital that needs investing somewhere).
Though one might assume that people in richer countries are in a better position to be the bigger savers, people in poorer countries have the greater incentive. If a country becomes rich enough that typical incomes rise above subsistence level, but still too poor to afford a social security system, then its people must save – or starve in old age (which they are now more likely to reach).
Something else that happens to countries when they escape poverty is that birthrates – and, hence, family sizes – come tumbling down, which puts paid to the traditional social security system of having lots of children and grandchildren to support you in your dotage. China’s one-child policy is an especially extreme example of this demographic phenomenon. Introduced in 1979, it coincided with Deng Xiaoping’s economic reforms. The latter freed China’s people to make enough money to save some of it, the former made it essential that they do so.
Finally allowed to profit from their labour (and accumulate savings) the explosion of enterprise from China’s peasantry, took the government by surprise – as Deng himself admitted in 1987:3
“The result was not anything I or any other comrades had foreseen; it just came out of nowhere.”
Today, it is forgotten that the Chinese economic miracle got its start in the countryside, not the cities – and that it was the spontaneous action of ordinary people, not central government planning that got it all going. However, through its control of the banking system, the state had a monopoly over the use of all those savings – a near-inexhaustible source of artificially cheap capital that was ploughed into the development of China’s industrialised export capacity. Growth thus begat more growth – and the accumulation of ever more capital. So much money, in fact, that not even China’s investment-led economy could absorb it all.
Xi Jinping gets a grip
Whether directed by the state, or by privately owned enterprises, or by China’s burgeoning middle class (only America has more people on salaries of $40,000 and above),4 vast sums of Chinese capital have been invested abroad. For instance, over the last decade, Chinese purchases in Europe include the Greek port of Piraeus, the Swedish car company Volvo, the Swiss pharma giant Syngenta and, of course, numerous helpings of London real estate.5
Western concerns about China’s shopping spree are, mirrored by Chinese concerns about the outflow of so much wealth. Things got so bad that by 2016 that the central bank was intervening to prop-up China’s currency (how times change).6
Xi Jinping likes nothing more than getting a grip – which he has done with the aid of tighter exchange controls and a shift to a more consumption-orientated economic policy. Fears of wholesale capital flight have subsided. Indeed, the net flow of capital is, for now, in positive territory, i.e. more flowing in than out.
So does that mean that Peter Thiel and Donald Trump can stop worrying? A China that is less export-orientated than it used to be, that won’t let its currency fall too low, and is keeping capital flows in balance, is surely less disruptive than it used to be.
And yet the potential for imbalance is huge. According to Michael Howell, managing director of CrossBorder Capital, China has accumulated $35 trillion in ‘liquidity’ – i.e. savings plus credit. This amounts to 27% of the global sum total – a proportion that has more than doubled over less than a decade, overtaking America’s share.7
Tweeting about Donald Trump last month, Kanye West vouchsafed that “we are both dragon energy”.8 I would suggest that the real ‘dragon energy’ in the world today is the power that the Chinese Government has over such a vast pool of capital.
In this respect, Xi Jinping is the world’s most powerful capitalist – quite a distinction for the world’s number one communist.