McKinsey: Umm, Yeah, About China's "Dangerous" Imbalances

Many, if not all, critics of Chinese trade and monetary policy point to China's massive trade surplus as a clear sign that the Chinese economy is too dependent on export led growth and is preying on the rest of the world through rampant mercantilism, particularly its "artificially low" currency.   For example, here's former free trader Paul Krugman on the subject:

The consequences of this policy are also stark and simple: in effect, China is taxing imports while subsidizing exports, feeding a huge trade surplus. You may see claims that China’s trade surplus has nothing to do with its currency policy; if so, that would be a first in world economic history. An undervalued currency always promotes trade surpluses, and China is no different.

And in a depressed world economy, any country running an artificial trade surplus is depriving other nations of much-needed sales and jobs. Again, anyone who asserts otherwise is claiming that China is somehow exempt from the economic logic that has always applied to everyone else.

Krugman is certainly not alone in this line of thought - one that we can call the "It's the trade surplus, stupid" (or "ITTSS") school.  Indeed, one of the biggest reasons that much of the punditocracy (and our glorious Treasury Secretary) believes that a revaluation of China's currency is absolutely essential for future global prosperity is the widely-held belief that the RMB's artificially low value has created huge global trade and investment imbalances.  Most notable among these imbalances, say the critics, are the United States' huge trade deficit and China's massive trade surplus.

Now, look, I'd never argue that the Chinese aren't pursuing some mercantilist policies - they certainly are (see, e.g., their awful "indigenous innovation" plans that hurt foreign market access and infringe on intellectual property rights).  But what if China's dastardly trade surpluses weren't nearly as big-and-scary as the ITTSS crowd thinks?  What if, as some folks (hint hint) have argued for a while now, old school trade statistics do a horrible job of capturing what's really going on in today's global economy, mostly because they don't/can't account for modern global supply chains and specialization?  Wouldn't that really put a big dent in folks' breathless/certain claims about the dire need for a significant and rapid "global rebalancing" through, among other things, a significant and rapid appreciation of China's horribly undervalued currency?

I think (hope?) most sane, non-political folks would say that revelations about the overstated magnitude of China's trade surplus should slow the intelligencia's mad dash to force a global rebalancing and a large appreciation of the RMB.  Several recent studies have provided such revelations, and a new study from McKinsey provides even more of them (emphasis mine):

[W]e developed a new way of measuring the role of export growth in China’s overall economic expansion. We found that exports have been a major driver, but not one as dominant as commonly believed. Indeed, there are clear signs that a shift toward domestically driven economic growth is well under way. The picture that emerges of the Chinese economy has implications for the growth and supply chain strategies of businesses in China and elsewhere....

Arguments over the true nature of China’s economic reliance on exports have been rooted in the difficulty of appropriately measuring the export sector. The traditional measure governments and most analysts use is the growth of total exports as a share of GDP growth. This measure indicates that export growth has accounted, on average, for almost 40 percent of the total growth in real GDP since 1990—rising to almost 60 percent since 2000. 

Yet these numbers, portraying a dominant and growing role of exports, are at odds with the fact that China was one of the few countries that escaped the great 2008–09 global downturn without a major economic slowdown—suggesting that internal growth played an important role.... 

Using total exports neglects the fact that many of China’s export shipments include a fair number of imported goods that are reassembled, combined with domestic content, or otherwise modified before being exported. Failing to remove these imports from the total export figure overstates how much value exports contribute to GDP.... 

We calculated a measure we call domestic value-added exports (DVAE) to assess more accurately the role of exports in GDP growth.  DVAE is what you get after subtracting from total exports only those imports used in the production of goods and services that are subsequently exported. In automobiles, for example, finished imports are not subtracted from our measure of exports. But engine parts imported to manufacture motor bikes for export would be....

On average, our analysis suggests that imported goods accounted for 40 to 55 percent of the value of total exports from 2002 to 2008. Put another way, roughly half of China’s exports represent domestic value added. Concurrently, DVAE’s share of exports generally has risen over time, suggesting that China has become less of a pure assembler of imported goods—a publicly stated government policy goal.... 

We also applied our DVAE analysis to reassess the contribution of exports to GDP growth in the years for which we have overlapping data among our three metrics. We found that China’s export sector contributed 19 to 33 percent of total GDP growth between 2002 and 2008 (Exhibit 1). That’s only about half of the export contribution indicated by traditional total-exports measures.

In other words, DVAE analysis suggests that exports have been an important driver of China’s growth, but not the dominant one, and that most common wisdom overestimates the role of exports while underestimating the role of domestic consumption for China’s growth. Any Chinese or multinational company that currently manufactures goods in China and primarily exports them to other countries should ask itself whether it needs to scale up its domestic strategy to get a bigger piece of the pie. This involves developing a more granular understanding of the Chinese market, making products that appeal to the Chinese consumer, and finding ways to market and distribute them effectively—all while contending with increasingly formidable Chinese competitors....

A comparison between DVAE’s contribution to growth and that of other major macroeconomic components shows that DVAE topped private consumption, but was less important than investment, over the 2002–07 period (Exhibit 2). In the downturn years, 2008 and 2009,5 exports contributed much less to growth than other factors did, which explains why the Chinese economy could not fully match its GDP growth rates in the earlier part of the decade. However, the shift to a greater role for private consumption, investment, and finished imports explains how China could weather the downturn well and indicates movement toward a domestically focused economy, even though exports will probably continue to play an important role when the global economy picks up....

In short, McKinsey's analysis demonstrates that China's economy is not nearly as export-dependent and "imbalanced" (and China's trade surpluses not nearly as significant) as Krugman and his fellow trade surplus disciples would have us believe.  It also demonstrates that, as Dan Ikenson has often noted, the evolution of global supply chains means that RMB appreciation could make Chinese manufacturers more competitive (through access to relatively cheaper imported inputs), not less so.  

So here's my question to Dr. Krugman, over 300 members of the US House of Representatives, Secretary Geithner, and the rest of the ITTSS folks out there:  is it really wise to pursue aggressive unilateral (or multilateral) action against China based on obviously sketchy trade data?

I dunno about you, but that seems a tad stupid to me.