Rebalancing is beginning, but it won't be easy

There has been a lot of misguided chatter over the last five years about how China's economy has been rebalancing towards a more healthy and sustainable growth trajectory.

Now, however, it may finally be beginning to happen.

Seen from the outside, it looks like China's economy has been rebalancing ever since 2007.

That's because foreigners tend to be worried their markets are being swamped by Chinese exports, while China isn't buying anything they manufacture. As a result, when they want to see how unbalanced China's economy is, they look at indicators like its current account surplus.

The current account is the broadest measure of China's trade balance. In rough terms, it tells you how much more China produces than it consumes, with the extra production equalling the surplus.

Viewed in these terms, China's economy reached its greatest imbalance in 2007, when the current account surplus hit an all-time high of 10 per cent of the country's gross domestic product (GDP).

Since then, however, China's current account surplus has contracted dramatically, falling to just 2.75 per cent of GDP last year.

From a distance, this may look as if China has indeed been rebalancing. Either more of what the economy produces is being consumed at home, or China is buying more stuff from the rest of the world. It's what other countries wanted to see.

But seen from a closer angle, it soon becomes apparent that up until the end of last year China's economy hadn't rebalanced at all.

To see why, we need to take another look at that current account surplus. While the current account represents the broadest gauge of a country's trade balance, it also measures how much excess savings a country has.

This makes sense because an economy's balance of payments always balances. If a country saves more of its income than it needs to fund its domestic investments, then it has to export the surplus cash. This cash is simply the current account surplus seen from another angle.

Viewed from this perspective, there are two ways an unbalanced economy running a large current account surplus can rebalance.

Firstly, people can save less of their income and spend more on day-to-day consumption. Alternatively, they can continue to save at the same rate, but invest more in building up fixed assets at home. Either way, the current account surplus will fall.

Up until the end of last year, China adopted the second path. The contraction in the current account surplus we have seen since 2007 took place not because the Chinese people were saving less of their incomes and spending more, but because the government ramped up domestic investment to use up more of their savings.

As a result investment rose to a record high as a proportion of GDP last year, while household consumption fell to an all-time low.

However, it's likely that trend began to reverse over the first half of 2012. We'll get a better picture when Beijing releases its economic numbers for second-quarter economic data this Friday. But from the data released so far, it looks as if the central government's curbs on property speculation have at last begun to have a significant impact on real estate investment.

According to the latest batch of figures, China's year-to-date growth in investment in residential properties dropped to just 15 per cent in May, down from a growth rate of 36 per cent in May last year. As a result, overall investment growth fell to a 20 per cent rate in May, down from a heady 26 per cent rate in May 2011.

This slowing is excellent news for anyone who believes China's investment rate was unsustainable and needed to fall for the economy to rebalance.

But there are a couple of catches. Firstly, slowing investment will mean a weaker growth rate for the economy overall; a three-year low of around 7.5 per cent looks likely for the second quarter.

And secondly, slowing investment coupled with continued high savings at home could cause a renewed widening of the current account surplus, leading to fresh complaints from abroad that China's economy is unbalanced. Beijing just can't win.