China’s 12th Five-Year Plan calls for a shift in the country’seconomic model from export-led growth toward greater reliance on domesticdemand, particularly household consumption. Since the Plan’s introduction, China’scurrent-account surplus as a share of GDP has indeed fallen. But does that meanthat China’sadjustment is on track?

Accordingto the IMF, the fall in China’scurrent-account surplus/GDP ratio has largely been the result of very highlevels of investment, a weak global environment, and an increase in prices forcommodity imports that has outpaced the risein prices for Chinese manufactured goods. So the fall in China’sexternal surplus/GDP ratio does not represent economic “rebalancing”; on thecontrary, the Fund predicts that the ratio will rebound in 2013 and approachits pre-crisis level thereafter.

The IMF’s explanation of the recent fall in China’s current-account surplus/GDPratio is broadly correct. Experience suggests that China’s external position is highlysensitive to global conditions, with the surplus/GDP ratio rising during boomtimes for the world economy and falling during slumps. Europe’s malaise has hit China’s exports badly, andundoubtedly is the most important factor underlying the current decline in theratio.

By definition, without a change in the saving gap, there will be no changein the trade surplus, and vice versa. Furthermore, the saving gap andthe trade balance interact with each other constantly, making them alwaysequal. In response to the global financial crisis in 2008, Chinaintroduced a RMB4 trillion ($634 billion) stimulus package. While the increasein investment reduced the saving/GDP ratio, the resulting increase in importslowered the trade surplus/GDP ratio. As a result, China’s external surplus/GDP ratiofell significantly in 2009.

In 2010, China’sgovernment adjusted its economic policy. In order to control inflation andreal-estate bubbles, the central bank tightened monetary policy and thegovernment refrained from another round of fiscal stimulus. China’sreal-estate investment accounted for 10% of GDP, and slower investment growthin the sector necessarily reduces import demand, directly and indirectly. But,because the fall in import growth had yet to turn into a rout, while China’sexports to Europe plummeted, China’scurrent-account surplus fell further in GDP terms in 2011.

This situation is likely to change in 2012. The negative impact of thefall in real-estate investment since 2010 has been deeper and longer thanexpected; indeed, almost all categories of imports that fell by 10% or more inAugust were related to real-estate investment. As a result, it is possible thatthe fall in investment growth will reverse the declining external surplus/GDPratio in 2012, unless the global economy deteriorates further and/or theChinese government launches a new stimulus package.

Perhaps most important, Chinamust now export more manufactured goods to finance imports of energy andmineral products. The worsening terms of trade have been a major factorcontributing to the decline in the current-account surplus in recent years.

Nevertheless, despite the merits of itsanalysis, the IMF underestimates China’s progress in rebalancing. Inmy view, China’s rebalancingis more genuine – and more fundamental – than the Fund recognizes, and theprediction of an eventual rebound in China’s external surplus/GDP ratiowill most likely turn out to be wrong.

First, the roughly 30% real exchange-rate appreciation since 2005 musthave had a serious impact on exporters, reflected in the bankruptcy – as wellas the upgrading – of many enterprises in coastal areas. Though the marketshares of Chinese exports seem to have held upquite well, this is attributable to price-cutting in foreign markets, which isnot sustainable. Over time, real exchange-rate appreciation will cause a shiftin expenditure, making China’srebalancing more apparent.

Second, China’swage levels are rising rapidly. According to the 12th Five-Year Plan, theminimum wage should grow by 13% per year. Together with real appreciation, theincrease in labor costs is bound to weaken the competitiveness of China’slabor-intensive export sector, which will be reflected in the trade balancemore clearly in the coming years.

Third, Chinahas made significant progress in building its social-security system. Thenumber of people covered by basic old-age insurance, unemployment insurance,workers’ compensation, and maternityinsurance has risen substantially. Moreover, universal medical insurance isemerging, and a comprehensive system for providing aid to students from poorfamilies has been established. As a result, the motivationfor precautionary saving has been weakened somewhat, while someresearchers have found statistical evidence that the consumption rate isrising, which is supported by China’semergence as the world’s fourth-largest importer of luxury goods.

Finally, the worsening of China’s terms of trade will play an even more fundamentalrole in reducing its trade surplus in the future. Given weak demand, which maybe prolonged, Chinese exporters must accept increasingly thin profit margins to maintain market share.However, China’slarge size and low per capita income and capital stock imply continuedrapid growth in its demand for commodities. Thanks to supply constraints, China’s importbill for commodities and metals is likely to offset its processing-tradesurplus in the near future.

In short, as long as China’sgovernment is not so unnerved by theslowdown in output growth that it changes its current policystance, the current-account surplus is more likely to continue to fallrelative to GDP than it is to rebound in 2013 and thereafter.In fact, such an outcome is not only likely, but also desirable. After all, faced with “infinite quantitative easing,” being a largenet creditor means being in the worst position in today’s global economy.