Would U.S. Tariffs Shift Beijing’s Focus to Consumption?

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Goldman Sachs analysts recently noted that while higher U.S. tariffs on Chinese goods could put downward pressure on China’s GDP growth, they could also force the long-awaited shift in domestic demand from investment and trade surpluses to consumption. “If Chinese goods face higher U.S. tariffs next year,” they wrote, “this would accentuate the shift towards domestic demand.” 

While this might indeed happen, it is not necessarily true, and understanding why it might or might not be true is helpful for understanding the economic pressures China faces. The basic assumption underlying the claim by Goldman analysts is that U.S. tariffs would force a contraction in China’s trade surplus.

This is the part that isn’t necessarily true. This claim assumes that tariffs on Chinese goods would cause a reduction in U.S. imports from China, which, all other things being equal, would in turn force a reduction in China’s total exports and therefore in its trade surplus.

But while this may sound superficially reasonable—this kind of incremental thinking is pretty common in discussions about trade—the assumption is wrong. Trade never clears incrementally. It only clears systemically, and external imbalances are always, and must always be, perfectly consistent with internal imbalances.

To put it another way, China runs a trade surplus because, by definition, it saves more than it invests domestically, which is just another way of saying that it produces more domestically than it consumes and invests—total production, after all, is either consumed domestically, invested domestically, or externalized in the form of a trade surplus.¹

Contrary to conventional thinking, however, there is nothing inherent in Chinese culture that requires high savings. As long as Chinese income is distributed in such a way that Chinese households cannot absorb a large enough share of what they produce, national savings (the savings of households, businesses, and the government) will exceed Chinese investment. In that case, China must run a surplus.

Something similar is true of the United States: for every country, external imbalances are always perfectly consistent with internal imbalances.² To the extent that China’s excess savings are used directly or indirectly to acquire U.S. assets, the United States must run a corresponding external imbalance: it must run a trade deficit. It doesn’t even matter whether or not U.S. trade with China rises or falls. If China directs its excess savings into the United States, the overall U.S. deficit must be sustained, even if its bilateral deficit with China falls.

This is why we have to approach trade systemically. Unless U.S. tariffs on Chinese imports are high enough to shift the distribution of income within China from producers to households, U.S. tariffs on Chinese imports will only shift the direction of Chinese exports and U.S. imports; so even as trade between the two is reduced, it won’t change the overall trade imbalances of either country. This, by the way, is exactly what happened after the administration of president Donald Trump first imposed bilateral tariffs on China in March of 2018: both China’s trade surplus and the U.S. trade deficit continued rising, just not with each other.

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But let us assume that U.S. bilateral tariffs on Chinese imports are so high—or, alternatively, that the United States implements more widely effective trade policies—that they result in a meaningful decline in the overall U.S. trade deficit. Given that the United States accounts for nearly half of global trade deficits, a decline in the U.S. trade deficit would mean that global trade surpluses, of which the largest is easily that of China, would also have to decline. How would a forced reduction in the Chinese trade surplus affect the Chinese economy?

There are several ways. First, remember that a contraction in China’s trade surplus must be mirrored in a contraction in the excess of Chinese savings over Chinese investment—once again, external imbalances are always consistent with internal imbalances.³

China, in other words, would have to adjust to a forced contraction in its trade surplus either with a rise in investment or a decline in savings. If the latter, China would have to rebalance with an increase in the consumption share of GDP, but there are both “good” and “bad” ways this could happen. Before discussing them, it is worth repeating that China does not have to adjust by rebalancing toward a higher consumption share. It can also adjust through a surge in investment, and in such a case, the economy would be left with even deeper imbalances.

This is exactly what happened after the 2008–2009 global financial crisis, when the resulting collapse in foreign demand caused China’s current account surplus to contract from over 10 percent of GDP to just over 3 percent. Of course, this meant that the excess of Chinese savings over Chinese investment also contracted from just over 10 percent of GDP to just over 3 percent, but instead of contracting from a decline in the savings share of GDP—which is the definition of a rebalancing toward a greater role for consumption—the savings share of GDP actually rose.

But because the rise in the savings share was more than matched by a surge in the investment share of GDP, the net result was that China’s surplus contracted sharply, but in a way that left the economy even more unbalanced than before. The consumption share of GDP declined and the savings share rose. More than 100 percent of the contraction in the surplus, in other words, was balanced by an expansion in the investment share of GDP.

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It is now widely recognized that this surge in investment severely exacerbated the problem of Chinese overinvestment, so why did Beijing choose a policy that resulted in a sharp rise in China’s debt burden and a worsening of China’s already deep imbalances? The answer has to do with how China might have reduced the savings share of GDP. 

The most obvious way that China’s saving share of GDP might have declined is if reduced demand for Chinese exports caused Chinese producers to close down production and lay off workers. Because unemployed workers have a negative savings rate (they consume more than they produce), rising unemployment would cause the excess of savings over investment to decline. But it would do so by causing a contraction in GDP (once-productive workers no longer produce anything), along with a contraction in consumption (unemployed workers have to cut back on consumption). Because the contraction in GDP would necessarily be greater than the contraction in consumption, the consumption share of GDP would automatically rise and the saving share would decline.

This is the painful way to rebalance. What if China doesn’t want to increase investment and it also doesn’t want unemployment to rise? In that case, the only thing it can do is implement policies that cause domestic consumption to rise by the same amount that the trade surplus contracts.

But this is not so easy. The sustainable way to accomplish this shift is to restructure the economy so that a larger share of production is diverted to the household sector—large enough that it results in an increase in consumption that matches the decline in the country’s trade surplus. China has been discussing doing this for well over a decade, without much success, and it is unlikely it could engineer this shift quickly enough to make up for a rapid decline in China’s trade surplus.

But there is another temporary way to cause domestic consumption to rise. This is either to force banks to boost consumer lending or to force local governments to borrow on households’ behalf and distribute the income to them directly or indirectly. The income distribution has to be large enough to set off a surge in consumption that matches the contraction in the trade surplus.

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These ways, then, account for all the meaningful options available to China if global trade conflict forces a contraction in the country’s trade surplus. To summarize: a contraction in the trade surplus is equivalent to a contraction in the excess of Chinese savings over Chinese investment. There are a limited number of ways this can happen: 

·      Investment can rise, but because worsening trade conditions are unlikely to set off higher investment by the private sector, the rise in investment will most likely be driven by government investment. Given how nonproductive this investment is likely to be—especially when the decision to invest is driven not by pull factors but by push factors (in other words, the need to increase investment to balance the contraction in trade)—higher investment will only worsen China’s imbalances, its malinvestment, and its debt problems.

·      Savings can decline as Chinese businesses meet weaker foreign demand by laying off workers.

·      Savings can decline as China restructures the economy. This is almost impossible to do quickly. Historical precedents suggest that it can take decades to accomplish.

·      Savings can decline temporarily as a surge in either household debt or government debt temporarily redistributes a part of total production to households, who then convert this into higher consumption.

In the end, the most Beijing can do is choose among these options if global trade conflict forces a contraction in the Chinese trade surplus. So, what will it do? In the past, there was no question that it would have chosen the first of these options (in other words, raise government investment). This is exactly what Beijing did in 2009–2010.

But given how widely it is now recognized that malinvestment has been China’s key economic vulnerability, there is a rising chance that it will not choose to do the same again. In that case, Chinese savings must decline one way or another.

Out of the three ways Chinese savings can decline, however, the first is politically unacceptable and the second is impractical, which leaves the third option, a temporary consumption stimulus. That means that unless Beijing is willing to accept a rise in unemployment, it must choose between a stimulus designed to boost investment and a stimulus designed temporarily to boost consumption. I think most analysts assume it will be the latter.

This is likely what Goldman analysts mean when they say that trade conflict “would accentuate the shift towards domestic demand.” If so, I suspect they are probably right.