China is extremely vulnerable to external pressure because its domestic market is shrunken and unbalanced. While the Chinese government may try to respond to American tariffs by depreciating its currency or using regulations to discriminate against U.S. companies, those measures have little guarantee of success. The better approach would be to focus on raising the incomes of ordinary Chinese so they can spend more.

Ironically, the threat of trade conflict with Americans could be good for the Chinese economy if it encourages the government to accelerate the domestic rebalancing that has been occurring since 2012.

Michael Pettis
Pettis, an expert on China’s economy, is professor of finance at Peking University’s Guanghua School of Management, where he specializes in Chinese financial markets.
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To understand why, remember that everything a country produces must either be used to satisfy domestic needs or be exported abroad. As long as the rest of the world absorbs those exports, households, businesses, and the government in the country can collectively save by spending less than they earn. Conversely, if spending on domestic consumption and investment is greater than domestic production, the difference has to be satisfied by imports. People are spending more than they earn and have to finance the difference by appealing to foreign investors.

One might expect China to have a significant trade deficit because the share of Chinese output spent by the government and businesses on infrastructure and capital expenditures has long been among the highest ever recorded. Yet China has had trade surpluses since the mid-1990s because spending on goods and services by Chinese households and by the government on behalf of households is extraordinarily low. The result is that the country’s savings rate is, remarkably, even higher than its investment rate.

This high savings rate, however, has nothing to do with the savings preferences of Chinese households. Rather, it is because most Chinese households get relatively little of the income generated by Chinese economic activity. The value generated by their labor is disproportionately captured by state-controlled businesses and the Chinese government.

If a global trade war crushed demand for Chinese exports more than it affected Chinese demand for imports, the difference between the country’s savings rate and its investment rate would have to narrow to match the decline in income earned by selling to foreigners.

There are four ways this could happen.

The government could boost domestic investment. That was the government’s response to the global financial crisis, which crushed the demand for Chinese exports in the rest of the world. The combination of China’s stimulus and weakness everywhere else caused China’s trade surplus to contract from roughly 7% of output in 2006-08 to less than half that level over the next three years. The stimulus, however, is now considered a mistake in China, since the country had already spent far too much on infrastructure and buildings it didn’t need before 2008. The additional investment caused debt to rise much faster than debt-servicing capacity, which is why China experienced one of the largest and fastest debt booms in recorded history.

As a result, the Chinese government has been trying to slow investment growth since 2011, and especially since 2014. A contraction in China’s trade surplus is therefore likely to lead to a lower savings rate rather than a higher investment rate. One way to do this would be through higher unemployment. People still need to eat even if they have stopped earning money, so soaring joblessness will mechanically lower the national savings rate. This is what happened in the U.S. during the Great Depression and in Greece more recently, but it is obviously something the Chinese government would rather avoid.

That leaves two other options.

The Chinese government could encourage households to save less and spend more by borrowing. Chinese household indebtedness has already exploded in the past five years and is now comparable to U.S. levels. Further increases in household borrowing wouldn’t be a viable long-term solution.

The only sustainable response, therefore, is for the government to rebalance the distribution of income that made China vulnerable in the first place. The Chinese government must dramatically increase the household share of national income so that domestic consumption rises quickly enough to absorb any reduction in the trade surplus.

This is easier said than done. Raising the income share of ordinary Chinese households means reducing the share that goes to powerful local governments and elites, referred to by Chinese Premier Li Keqiang as the “vested interests.”

While China began rebalancing in 2012, this has occurred far too slowly to bring debt under control, much less allow China to weather a trade war.

That is why, amid the deepening worry that seems to have overcome Beijing in the past few months, there is one quiet source of optimism: The threat of a trade war will allow Beijing to smash through vested-interest opposition to economic rebalancing. If it doesn’t, the only other options will be rising joblessness or even more debt. 

This article was originally published in Barron’s.