By chief economist Shen Minggao and economist He Yin

(Caijing.com.cn)Exports, or more precisely, net exports, have been the main driver of China’s rapid growth since the beginning of this century. In contrast to the 260 percent growth in GDP between 2000 and 2008, China’s net exports increased eleven-fold during the same period. In 2005, net exports accounted for 33 percent of GDP growth, followed by 26 percent and 19 percent in the next two years, respectively.
 

With the world sinking into recession, the rapid expansion of China’s exports halted in late 2008. As a result, net exports have been shrinking, dragging down 2008 GDP growth instead of propping it up. In February 2009, China’s net exports were 43.4 percent less than over a year ago, a drastic drop even after taking into account the customary fall following the Spring Festival. The odds are that net exports will no longer act as the engine of China’s economy.
 

In order to forecast China’s net exports for 2009, let’s take a closer look at the affecting factors. Textbook economics suggest that net exports are usually linked to a number of factors including: demand preference for domestic vs. foreign products, domestic consumption and investment, trade partners’ GDPs and fiscal deficits, the relative size of a country’s per capita GDP compared to that of its trade partner, and the exchange rate between the currencies of the two trading parties.
 

A study of the quarterly trade balance between China and its nine major trading partners from 2000 to 2008 reveals that five of the seven factors listed above, with the exceptions of domestic consumption and fiscal deficit of the trading partner, correlate significantly with China’s net exports.
 

To begin with, Chinese consumers, like in most countries, prefer domestic products over those produced abroad. Preference is measured by the difference between the percentages of the domestic purchase and domestic production of a certain product; the greater the preference, the fewer the imports and the faster net exports grow. However, this is not a major driver for China’s net exports, as a 50 percent increase in domestic preference only translates to a marginal 0.05 percent growth of net exports.
 

With regard to domestic investment, conventional wisdom suggests that higher fixed capital investment will result in slower net export growth one or two quarters later because new investments boost the demand for imported machineries, thereby reducing net exports assuming that exports hold flat. 
 

But the finding is that, over a longer period of time, with new fixed capital investment materialized into production capacity, an additional percent of investment would push up net exports by 2.8 percent a year later. That is to say, keeping the external demand for China’s exports unchanged, a 20 percent increase in fixed capital investment will, by enhancing production capacity and thus supply, accelerate net export growth by over 50 percent. However, as the February data suggests, when external demand slumps as what is happening now, a 20 percent increase in fixed capital investment could produce a mere 5 percent growth in net export.
 

The third parameter to examine is a trade partner’s economic growth – stronger growth means greater demand for China’s exports and, thus, a larger trade surplus. According to our research, 1 percent average GDP growth for China’s nine major trade partners would elevate China’s net exports by 11 percent. 
 

Considering per capita GDP, a greater ratio of China’s per capita GDP against that of the trade partners would blunt China’s production cost edge, moderating the growth of Chinese net exports – a 1 percent increase of this ratio would reduce China’s net exports by 1.2 percent.

Lastly, a weaker yuan in the previous quarter also contributes to faster growth of net exports – yuan depreciation of one percent would lift net exports by 1.3 percent. The implication is that China can use the exchange rate as an effective tool to address the trade imbalance.

After sorting out the relevance of each factor, we can forecast China’s 2009 net exports by applying the correlations to a number of macroeconomic indicators.
 

There are already quite a few projections available: the International Monetary Fund forecasted negative growth of 1.6 percent and 2.0 percent for the US and European economies, respectively; Standard & Poor’s predicted a four percent contraction of Japan’s GDP; Citibank put the growth rate for both South Korea and Taiwan at around -5 percent. 
 

Therefore, it would be safe to assume a two percent decrease in GDP on average for China’s nine major trade partners, which would wipe away 22 percent of China’s trade surplus with these economies.
 

If China’s expansion is in the territory of 7 percent, China’s per capita GDP growth would be over 10 percent higher than that of its trading partners. As said above, the resulting weaker cost advantage would cut China’s net exports by 12 percent, ignoring the change in labor productivity. Since people tend to work harder for fear of being laid off when the economy deteriorates, as observed in the Great Depression of the 1930s, the diminishment of China’s cost advantage might be partly offset by a swifter labor productivity rise relative to its trading partners.
 

To sum up, we conclude that China’s net exports this year are likely to shrink by 30 percent, lowering the figure to US$210 billion from US$297.3 billion in 2008.
 

A seemingly contradictory fact is that China’s net exports increased 50.8 percent in the first quarter. However, this is unlikely to continue given stabilizing commodity prices and fast-growing investments that will probably boost imports more than exports.
 

Of course, the accuracy of the above theoretical analysis could be undermined by a number of practical uncertainties. For example, the yuan would be de facto appreciating against other emerging market currencies given their sharp depreciation against the dollar, rendering China’s exports less competitive. Another risk is revived trade protectionism against China’s exports, eliminating any benefits to the Chinese government’s increased VAT rebate. 
 

The hope is that China will manage a timely transformation of its economic growth model from export-driven to domestic-demand-driven, enabling China to rely less on net exports for growth.