Last week's trade numbers from China could not have been more dismal. After declining by 2.8 per cent year on year in December, China's exports plummeted 17.5 per cent in January, placing huge pressure on the country's manufacturing sector. Already unemployment in China is surging.
Chinese import numbers are even more dismaying. After dropping 21.3 per cent in December, imports fell a staggering 43.1 per cent in January.
At first glance there seems to be a silver lining in the export numbers: they are not as bad as those reported by some other Asian countries. In December, for example, Taiwan's exports fell by 42 per cent, South Korea's by 17 per cent and Japan's by 35 per cent, capping many months of contraction. Less developed Asian countries also performed worse than China, which suggests China may have increased its competitive edge over its trading rivals. But it is precisely this relative outperformance that indicates the severity of the adjustment yet to take place. China's trade surplus for January was a mind-blowing $39.1bn (€31.1bn, £27.4bn), just under November's all-time high of $40.1bn and edging out December's $39bn for second place. In comparison, in the first half of 2008 China's average monthly trade surplus was an already high $16.7bn. In the second half it surged to $32.9bn.
The global economy is experiencing a sharp contraction in demand – which must be “shared” among all of the world's producers. The decline in Chinese exports means that Chinese producers, of course, are absorbing part of that contraction; but the bigger decline in imports means that Chinese consumers are contributing a greater amount to the contraction in global demand.
The net result is non-Chinese producers must absorb more than 100 per cent of the contraction in demand from non-Chinese consumers. In a world of contracting demand China, the world's leading exporter of overcapacity, is actually adding to global overcapacity. It will be hard to convince China's trading partners that this is fair.
But this does not mean that Chinese policymakers are knowingly engaging in predatory trading behaviour. On the contrary, although they seem unable – some might say unwilling – to understand China's role in the global imbalance (much like the US failed to understand its role in 1930), they would nonetheless like nothing more than to see China increase consumption sharply. To that end they have unveiled a fiscal stimulus package and forced banks to expand lending at a pace so rapid – January's new loans equalled one-third of all new loans in 2008 – it will almost certainly lead to a sharp rise in non-performing loans.
But in fact their efforts have only increased total consumption, not net consumption. China's outdated development model, a banking system that seriously misallocates capital and its weak consumer base make it very difficult for China's fiscal stimulus to cause a rapid net increase in consumption.
Take the recent expansion in lending. The Chinese banking system in some sense is the mirror image of that of the US. Whereas American banks accommodated expansion of liquidity of the past decade by making imprudent loans to the consumer sector, Chinese banks responded to their own surge in domestic liquidity by channelling lending into overinvestment.
US banks are cutting off consumer lending as they contract, but Chinese banks are actually increasing their lending to the manufacturing and infrastructure sector in order to generate growth and employment. Although the employment effect of this lending will contribute to total global demand if it takes workers off the unemployment queue, the consequent increase in production may easily overwhelm it, so that China will continue to export huge amounts of overcapacity into a world struggling with collapsing demand.
This can easily lead to worsening trade friction. Already Asian countries from India to Indonesia are squabbling fiercely over Chinese exports and western economies from France to the US are veering towards protection.
But trade war is not the solution. Threatening China with trade sanctions if it does not rapidly reduce the rising overcapacity it is forcing on to the rest of the world will not work. There is very little Chinese policymakers can do in the short run without causing a collapse in the export sector and a rise in unemployment so rapid that it could lead to social instability.
The world must recognise that China can adjust, but it cannot adjust immediately. It will take several years to do so, and will require significant changes in both its financial system and in its development model. To that end large economies need to work out a plan in which China is given a reasonable amount of time to make what will inevitably be a difficult transition. As part of the plan, the US, Europe and other big economies must assure open markets to Chinese exports.
The world, with US president Barack Obama in the lead, has a tremendous opportunity to help China through a difficult transition and, in so doing, create a new sustainable global balance of payments and a favourable institutional framework that will govern trade and capital relations for decades to come. If not, the advantages trade deficit countries receive from pushing the full burden of adjustment on to trade surplus countries will be overwhelmed by a global environment of deep mistrust and hostility.
This is not the time to attack China. China has a serious overcapacity problem that can best be worked out in global co-operation over four to five years. To demand a quick resolution will bring nothing but trouble.
The writer is a professor of finance at Guanghua School, Peking University