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China's Deficit and the Risks of Economic Transformation March 10, 2011 | 1708 GMT PRINT Text Resize: ShareThis FABRICE COFFRINI/AFP/Getty Images Chinese Commerce Minister Chen Deming in Davos on Jan. 27 Summary China posted a $7.3 billion trade deficit in February, a rarity for a country that is better known for massive trade surpluses. The deficit comes as China tries to retool its export-driven economy as a domestic-consumption driven economy without slowing growth too drastically. The surge of commodity prices has added a new element of risk in Beijing’s effort to transform its economy, making deficits more likely. While there is not yet reason to assume that China is on the path toward consecutive deficits, such a development would mark a significant change. Analysis China’s General Administration of Customs recorded a $7.3 billion trade deficit for February, the largest since February 2004. Exports rose only 2.4 percent compared to the same period last year, while imports climbed 19.4 percent; both figures were lower than expected. Trade deficits are rare for China, which is famous for its massive surpluses. Economic statistics in China often contain peculiarities related to the annual lengthy nationwide Lunar New Year celebrations, during which domestic spending rises and industry grinds to a halt. The holiday took place in February this year; its effects lasted for more than the official one-week celebration. According to Bloomberg, January and February saw a combined deficit of $890 million, as opposed to a surplus of $22 billion in 2010 during the same period. There is more to the trade deficit than the seasonal factor, however. Reshaping the Chinese Economy China is in the midst of attempting to reshape its economy to reduce dependence on the export sector and convert domestic consumption into the driver of growth. Exports dove during the global economic crisis, and domestic spending surged, fueled by bank lending for central and local government development projects and the expansion of state-owned enterprises. In 2010, exports recovered, but China maintained the domestic investment drive because of lingering uncertainties. As an economy driven by household consumption is nowhere near taking shape, and as the export model of growth is increasingly being accepted by policymakers as unsustainable, Beijing can be expected to maintain high levels of government-driven investment for some time in an attempt to restructure the economy. (click here to enlarge image) The need for economic restructuring has resulted in increased imports in China to fuel development of its interior regions, trying to acquire key technologies to upgrade its industries, and also trying to expand its services sector and consumer economy. At the same time, China needs to import more goods from other countries to alleviate trade frictions, an active theme in negotiations with the United States and at the G-20, where China encounters pressure to reduce its trade surpluses and appreciate its currency. China has sent trade delegations to make large purchases to address this issue. With the Communist Party pursuing this economic restructuring, Commerce Minister Chen Deming emphasized March 7 that some monthly trade deficits cannot be ruled out this year. China had raised the possibility of more frequent monthly trade deficits in early 2010 — recording a deficit in March that year — with the same goal of reducing trade surpluses as a share of the economy to aid the rebalancing effort. While China is not currently expecting an annual trade deficit, its annual trade surpluses in 2009 ($196 billion) and 2010 ($184 billion) were roughly $100 billion lower than its surpluses in 2007 ($264 billion) and 2008 ($298 billion), closer to the 2006 level of $177 billion. The Risks of Economic Transformation China’s attempts at economic transformation are not without enormous risks. Were China to record several back-to-back trade deficits, concerns would emerge about the drying up of cash flow, which enables many inefficient businesses to continue operations. China accordingly fears that overly drastic or sudden change could end up slowing growth sharply, sending waves of unemployed persons on to the streets, hence the policy attempts gradually to expand imports. Moreover, the surge of commodity prices globally — exacerbated by unrest in the Middle East — has added a new element of risk for Beijing. With China’s booming demand, high prices bring more inflation into the country, putting price pressure on businesses and consumers. China cannot simply curb its demand for fear of a slowdown. It is instead stockpiling materials such as oil, iron ore and copper at high prices to fill strategic reserves and prepare for even higher rising prices (and for speculation as well), thus contributing to international price rises. Oil stocks were depleted in the last part of 2010 because of a rush to meet energy-saving goals by year’s end. Building those stocks back up now is expensive. Highlighting the impact of high prices, Bank of America Merrill Lynch estimates that for every additional dollar to the price of a barrel of oil, China’s annual trade surplus will fall by $1.9 billion. Put simply, China remains hugely dependent on imports to fuel growth, and rising import prices play into deficits that it must be careful not to expand too quickly. The Chinese government’s reluctance to let high international commodity prices add greater upward pressure to domestic prices means the state will attempt to intervene, using such tactics as price controls and price-hike delays on fuel. Refiners already are operating at a loss due to high international oil prices and low domestic prices. As with the steel sector, which is suffering from high iron ore and coking coal prices, the government will have to lend support if profit margins diminish or disappear. Beijing thus is pursuing a policy of reshaping its economy that will surge imports at a time when import costs are booming and inflation is stoking social frustrations. While there is not yet reason to assume that China is on the path toward consecutive deficits, such a development would be quite significant.