A recent article in the South China Morning Post claims that “shipping agents across China are struggling to find cargo during what is traditionally the peak shipping season ahead of Western holidays.” This is happening, the article says, because of a rapid fall in expected demand, the article calls it “plummeting demand,” from the United States and Europe for Chinese imports. Figure 1 below, based on data cited in a recent Economist article, shows how sharply container-shipping costs have fallen as a result of weaker demand.

China’s large structural trade surpluses are the consequence of internal economic imbalances, which means that any external pressure that results in a contraction of its trade surplus must be accommodated by shifts in these internal imbalances.

I have no special insight into whether the growth in global demand for Chinese goods will decline over the rest of the year and how rapidly such a trend would set in, but working through the consequences of an external adjustment to China’s internal economic imbalances is a useful way of illustrating the equilibrating role of the country’s trade surplus within the broader economy.

By definition, a country’s current account surplus is equal to its excess savings (which over the rest of this essay will mean its savings minus its investment). Although there is a difference between a country’s current account surplus and its trade surplus, for the purposes of this analysis the difference is not meaningful, and I will treat the two as equivalent. With that in mind, China’s trade surplus can be said to be a function of the gap between domestic savings and domestic investment or (to put it another way): net exports = savings - investment.

For those uncertain about the accounting identities, I explain them in more detail in this February 2017 essay. If there is a rapid decline in export growth driven by external conditions (such as slower growth in the United States and Europe that causes them to import less from China), such a trend could be partially balanced by a decline in import growth, but otherwise this should cause net exports to decline. Such a decline in net exports must be balanced either by a rise in investment, a decline in savings, or some combination of the two. Because any given country’s internal imbalance must be consistent with its external imbalance, in other words, it is impossible for net exports to contract without a simultaneous contraction in the excess amount of domestic savings over domestic investment.

It turns out that there are several ways—some of them good and some of them bad—by which the gap between savings and investment could narrow. Put another way, there are a limited number of ways in which investment can rise and a limited number of ways in which savings can decline, with each representing very different sets of economic conditions. The rest of this essay will list the most likely ways in which China’s net exports can contract in and the conditions associated with each.

A Rise in Unemployment

One way to balance a decline in net exports would be with an initial rise in investment driven by rising business inventories, so that the contraction in net exports would be matched by a rise in unwanted investment. If Chinese exporters suddenly and unexpectedly find themselves unable to sell everything they have produced and had previously sold abroad, the unsold production will accumulate as unwanted inventory. Notice that this is enough to satisfy the identity linking net exports with excess savings. In this case, it would manifest as an increase in investment.

Of course, this isn’t a sustainable course, and if inventories were to continue to rise, Chinese businesses would quickly cut back on production, which would in turn force them to fire workers. Unemployed workers have a negative savings rate—they consume more than they produce, unlike employed workers, who usually produce more than they consume—so the rise in unemployment would cause Chinese savings to drop.

Again, notice that this development also is enough to satisfy the identity linking net exports with excess savings: a drop in net exports is matched with a decline in savings through rising unemployment, so the gap between savings and investment declines in line with the decline in net exports.

This isn’t a good outcome, but it is likely to be made much worse if businesses react to weaker export demand not just by firing workers but also by cutting back on investment. In such a scenario, savings would have to decline by a lot more to maintain the balance, and the decline in savings would most likely occur in the form of an even greater rise in unemployment. This is the kind of downward spiral that Beijing wants urgently to avoid.

A Rise in Government Investment

Although China’s business sector is more likely to respond to a contraction in exports with a reduction in investment rather than a rise, businesses are not the only source of investment in an economy. The government can also increase its level of investment by, for example, building more infrastructure or encouraging property developers to increase investment by building more buildings.

In fact, over the past three decades this is how Beijing has consistently responded to adverse trade events or any adverse economic events: it has boosted investment in property and infrastructure, effectively transferring workers who are no longer able to produce for export sectors to the construction sector and related economic activities associated with investment in property and infrastructure. Notably, property and infrastructure construction accounted for more than 25 percent of China’s economic activity last year.

While this response helped the Chinese economy grow sustainably in the past, when the country was still underinvested in residential and commercial property and in infrastructure, China’s extraordinarily high investment growth rate was inevitably going to close the gap between its level of investment and the amount of investment it could productively absorb. Once that happened, and it probably happened sometime between 2006 and 2008, the problem with relying on surges in property and infrastructure investment to manage a decline in exports was that such tactics could only lead to an increase in the country’s debt burden.

This is exactly what happened in 2009 and 2010, when Chinese exports (along with the country’s trade surplus) dropped by several percentage points of Chinese GDP. Beijing responded with a surge in government-directed property and infrastructure investment leading to what many believe was the beginning of China’s unsustainable debt surge.

Whether or not this investment is productive, this is one of the ways China can try to balance out a decline in net exports. The increase in investment isn’t sustainable in this case because it is backed by an unsustainable increase in the country’s debt burden, but it nonetheless reduces the gap between savings and investment in line with the contraction in net exports.

A Rise in Household Debt to Fund Household Consumption

If a sharp drop in exports coincides with a sharp rise in household borrowing to fund consumption, the contraction in the Chinese trade surplus can also be matched with a contraction in Chinese savings as Chinese production is diverted from exports to domestic consumption. This contraction in Chinese household savings—equal to the rise in household debt, which is just negative savings—would occur as Chinese households were to divert a larger share of their income to consumption and, consequently, a smaller share to savings.

Like in the case above, a contraction in exports would be balanced out with a rise in debt, although in this case it would be household debt rather than corporate or government debt. While this could be a temporary response to a contraction in exports, over the long term this approach wouldn’t be sustainable either. What is more, the solution would only be a temporary one and would be reversed if households ever decided to cut back on their total debt.

A Rise in Household Consumption Funded by Government Borrowing

If Beijing were to respond to a sharp drop in exports with a sharp rise in government borrowing to fund consumption, once again the contraction in the Chinese trade surplus could be matched with a contraction in Chinese savings. The main way in which this might happen would be if the government (mainly local governments) were to borrow money to fund consumption on behalf of households, such as school costs, medical bills, or higher pension payments.

This policy option would work in much the same way as the case above, in which a rise in consumption would be funded by household borrowing. The only difference is that in this scenario the impetus for borrowing has shifted from households to the government. As in the case above, the solution would only be a temporary one and would be reversed once government officials were forced either to cut back on their total debt or to turn to taxation or monetization to service their debt.

A Rise in Household Consumption Funded by Income Transfers

Finally, the only sustainable way that China can accommodate a drop in export growth would involve something it has discussed for more than fifteen years but has found politically difficult to do. By transferring money from low-consuming sectors of the economy to ordinary households (which in practice really means transferring wealth and income from local governments to households), China could cause consumption to surge because of a surge in household income. If the consumption share of GDP rises, by definition, the savings share declines, so a contraction in China’s net exports would once again be balanced by a contraction in the excess difference between savings and investment.

This is similar to the case above insofar as transfers from the government to households could be funded by government borrowing. The difference is that a surge in government borrowing is ultimately unsustainable, whereas if the transfers are funded by the direct or indirect liquidation of government-owned assets, this practice would be sustainable, though it would also be politically contentious.

China’s Fateful Choice

The important point is that if there is an unexpected decline in China’s trade surplus, Beijing must either choose to follow one of the paths above, or else one of those paths—most likely surging unemployment—will be forced upon it. All the various paths can be summarized as involving some combination of either higher unemployment, higher debt, or income transfers (preferably from local governments) to households.

In previous years, Beijing has always chosen the second of the paths described above (a rise in government investment), although more recently it has also encouraged the third path (a rise in household debt to fund household consumption). The problem with the latter is that household debt levels are now too high for this to be a likely solution.

Because Beijing has become increasingly disinclined to allow property investment to continue rising, this suggests that the most likely choice is a renewed surge in government investment in infrastructure and, with it, an acceleration in the country’s debt levels relative to the growth in GDP. Many economic policymakers and advisers in Beijing recognize the unsustainability of this path and the risks it poses for the Chinese economy, but I suspect it will be much harder politically to allow growth to slow and unemployment to rise, and it would likely be impossible to manage transfers to the household sector at nearly the rate and speed needed for rising consumption to balance a decline in net exports.

I should reemphasize that I don’t know if export growth in China is likely to slow dramatically in the coming months. This will depend on whether there is enough of a slowdown in the growth of U.S. and European demand to counter policies in China aimed at subsidizing and expanding manufacturing. Beijing’s supply-side stimulus measures have forced growth in the country’s total output—even if this represents much slower growth than in the past. But for all its talk about boosting domestic demand, Beijing has found it almost impossible to keep domestic demand from stagnating, so over the past two years it has become increasingly reliant on its soaring trade surplus to reconcile weak growth in output with even weaker domestic demand.

My guess is that, given Beijing’s aggressive support of supply-side measures (when it really should be implementing demand-side measures), the Chinese share of global exports and global manufacturing will keep expanding as China’s industrial output rises. But whether Chinese exports will continue to grow rapidly, will grow more slowly, or may even contract is hard to say. The key, I suppose, is what happens to global demand. But one way or another, if export growth slows enough to cause a substantial contraction in China’s trade surplus, Beijing will most likely have to respond either with a further increase in infrastructure investment (and in the country’s debt burden) or it will have to allow unemployment to rise.

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