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Glenn Profile picture
@GlennLuk
Oct 29, 2024 • 45 tweets • 15 min read • Read on X
Contrary to a popular mainstream view, China's trade surplus has likely been overstated by hundreds of billions per year dating back more than a dozen years.

This 🧵 is a direct rebuttal against claims that the recent changes in BoP methodology are leading to systematic understatement of its trade and current account surplus.

Instead, I show how the change in methodology has addressed prior distortions.

@IMFNews @Brad_Setser
To understand why, we need to go back to the the 19th century during the first globalization boom.

This was a time when physical trade flows largely matched funds & value flow, as products produced entirely in one region were traded for those produced entirely in others. Image
Fast forward to present day: Trade has gotten significantly more complex.

Lower friction costs of trade made it possible to separate/outsource different segments of the mfg. value chain.

Int'l tax laws incentived firms to shift profits, which distorts customs data.Image
This is especially true for China, which became the world's factory floor — with the implication that China is the final destination for most of the world's manufactured consumer goods by global brands before they are shipped all around the world. Image
Rising mfg. complexity & profit-shifting increasingly untether measured physical trade flows from underlying value/fund flows.

The iPhone is one of the best illustrative studies.

This diagram shows how China Customs measures it using physical trade flows. Image
But if we examine actual fund flows — which is the ultimate objective in measuring trade — China switches from being counted as a large net exporter ($31.2B) of iPhones to a larger importer ($21.6B).

This is a $52.8B swing/distortion for a single product from one company.Image
Ultimately the direct funds flow approach is more accurate than the physical flows approach.

After all, China Customs' measurement of physical trade flows had merely been used as a proxy for the underlying fund flows & value transfers. Image
We can further break down the physical vs. fund flows distortions into two key categories.

First, is the overstatement of exports using physical vs. fund flows.

This is driven by the difference b/n customs valuation and actual payments to the contract manufacturer.Image
While there is some debate on the exact magnitude of the difference between customs value and payments to the contract manufacturer — as it will vary by industry and product — we know that it can only be distorted in one direction (i.e. overstatement).
Customs value cannot go below amounts paid to the contract manufacturer, but it can be much higher.

This was confirmed recently when analyzing differences in custom valuations between the U.S., Japan and Ireland for the iPhone.

Secondly, there is another key distortion on the measurement of imports between physical and funds flows approaches.

This time it is an understatement — which leads to further overstatement of the surplus.Image
As mentioned earlier, combined these distortions add up to an estimated $52.8B just for the iPhone.

And these distortions are not Apple-specific or limited to bonded zones.

They are features of most relationships between foreign brands and Chinese contract factories. Image
For example, we see the same phenomenon with global footwear brands like Nike and Adidas that manufacture shoes in China for customers both outside and within China.

Within branded footwear, I calculate a net overstatement of $27.5B.

Less than the iPhone, but still material. Image
Image
Indeed, we can generally apply this analysis across all sectors where foreign brands contract manufacturing to Chinese factories. Image
The scope of this net overstatement is large.

I estimate distortions equal to 3.2-4.7% of exports (as measured by China Customs) and 1.1-1.6% of imports, amounting to a combined $142 to 212 billion in '22 — and even this may be quite conservative.Image
Keeping all of this context in mind, the change in methodology in 2021-22 from using China Customs physical flows data to underlying funds flow data kept by SAFE (e.g. FX transactions and reported financials) was most likely to correct for these known distortions. Image
Correcting these known, observable distortions is a far more plausible explanation than speculative claims that the methodological changes were made as a way to understate or otherwise hide its trade surplus. Image
Indeed, as I discussed in my initial thread on the topics a few weeks ago, there are no signs of a the "hidden capital flight" that would be a necessary balancing implication of a current account surplus that is understated by half a trillion dollars.

Instead, this corrects longstanding physical vs. fund flow distortions that have been steadily rising from:

(i) ↗️ exports
(ii) ↗️ use of Chinese contract mfgs, and
(iii)↗️ sophistication of int'l tax optimization strategies via profit shifting to tax havens like Ireland
Indeed, if we apply general assumptions on distortion levels to BoP figures dating back to 2012, we can see how they adjust E&O in a way that is still consistent with known "hidden capital flight" surges like 2015-18 and 2021-22. Image
Further analysis will be helpful to further refine these assumptions but the general conclusion here is that it is far more likely that Chinese trade surpluses have been overstated rather than understated over the past dozen years.
Responses to Brad to follow:
1. U.S. customs price shows material diff b/n reported customs valuation ($400/iPhone) + iPhone BOM ($270/iPhone), creating the distortion.

The chart below actually confirms the idea raised in CF40 report that Chine’s reported customs exports match trading partners’ import data.
I go into detail in this prior thread to calculate the estimated difference between customs valuations & average iPhone BOM.

Brad keeps citing BOMs for high-end iPhones but the avg. iPhone is $885/retail, suggesting a significantly lower avg. BOM vs. high-end models.
Ireland’s much lower customs import price for iPhones strong indication of what is paid to contract manufacturers.

Ireland is a special case because IP is legally domiciled there for international sales.

(U.S. is also special because IP is developed in Cupertino)
2. I do not see the basis for the assertion that customs distortions only arise out of bonded zones.

China and IMF refer to “factoryless” manufacturing, which is much larger than trade our of bonded zones.
I specifically addressed this in my thread here using the example of branded footwear.

Thus Apple and bonded zones cannot represent an “upper bound” on possible export distortions.
3. I also addressed the import understatement issue in my thread.
The specific critique is with Brad’s proposed adjustments.

I agree it would be accounted for in the old methodology as a separate services, royalty or profit line item.
But in Brad’s adjustment, he compares the Customs surplus (which does not include this adjustment) with the new BoP surplus methodology based on fund flows (which does).

This is not apples to apples.
Thus, adding the full gap between Customs data and (post-adjustment) BoP Surplus double-counts this import understatement adjustment.

My position is that the new methodology properly accounts for the export overstatement and this import understatement.
4. If there are valid reasons, such as the rise of these identified distortions, then making the move to the new methodology that ends up reduces E&O should provide comfort, not arouse suspicion.
E&O could be a function of distorted official measures (such as the customs exports overstatement) or it could be a sign of hidden capital flight.

What doesn’t pass the sanity check are logical implications of Brad’s position that China’s CA surplus should be adjusted by $500B.
I discussed why here. There’s just no smoke / evidence that there is hidden capital flight anywhere close to the $500B that would be required to balance out the proposed adjustment.

I’m happy to change my position if evidence can be found of this, but none has been offered.
I have compiled customs data from OEC for 2022 for some of the larger European countries to fill in some of the remaining gaps.

Est. customs value for iPhone is significantly higher than U.S. (as expected) but also higher than Japan. Image
This raises the $/unit customs average to $457. I have used this data to update the previous slide: it now covers >90% of exported iPhones from China.

I've tweaked some of the assumptions (BOP as a % of retail, iPhone/Android price ratio) to be even more conservative. Image
Updated export overstatement of $27B representing ~32% of the customs export value.

Compares to 10-15% on foreign brand exports, which are ~1/3rd of total exports. This is appropriately conservative, as an iPhone has relatively high intangible content.

This '21 paper examines the "factoryless" mfg. and distortion effect on "trade vs. income flows".

Based on five US "factoryless" cos (Apple, Nike, Qualcomm, Cisco, AMD), researchers found $70B (~36%) of trade distortion on $190B in int'l revenue.

ideas.repec.org/p/ngi/dpaper/2…Image
Image
Image
This is consistent with the up-to-date analysis I have done on the Apple iPhone, providing a nice sanity check.

This distortion is generally applicable to all "factoryless manufacturing" where a foreign company works with a Chinese contract manufacturer.

This includes most of the $1.1T in exports that include a "foreign-funded" exporter (e.g. Foxconn, Pou Chen)

In other words, it is not just "bonded zones", which are a subset of "factoryless manufacturing" for products like the iPhone where there are large number of finished components that need to be handled logistically.

To calculate the range of potential distortions, I use 10-15% of this $1.1T in exports by foreign-funded entities.

This is actually quite conservative based on the Apple and Nike examples, where intangible asset (e.g. brand, tech) make up the majority of the value.
The value recorded by China Customs for exports is typically based on the Transaction Value method and determined by the importing firm, not by China Customs or the contract manufacturer.

bdo.com/insights/tax/t…
As noted here, intangible value like IP and royalty license should be included in this valuation.

The customs valuation is relevant for the importer because that is the value on which potential duties and VAT are calculated by the importing country. Image
Image
The Transaction Value (TxV) method is the dominant form to estimate customs valuation, used in “90-95%” of transactions.

It’s discrepancies between TxV — determined by the importer — recorded by China Customs and the price paid to the CM that create export overstatement.

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More from @GlennLuk

Glenn Profile picture
May 31
Chinese chip designers finding workarounds for EDA software is roughly the same degree of difficulty / switching cost as moving away from CUDA/nVidia.

This is an effort measured in months, not years.

eetimes.com/u-s-restricts-…
By comparison the advanced lithography ban was an OoM more complex/difficult and the switching cost process measured in years, not months.

That was the largest source of leverage in the American tech/economic dominance toolkit and it was played early.
The other comp here is developing a homegrown OS and attracting a developer base.

Replicating EDA software and supporting libraries is the same order-of-magnitude task.

The development takes years, but this effort was also started years ago, with real efforts kicked off after the Meng arrest in 2018.
Read 11 tweets
Glenn Profile picture
May 14
Saying Apple "invests $55B in China every year" is financially illiterate nonsense.

We know exactly how much Apple has invested in China, as it discloses annually in its annual 10-K.

Apple has cumulative investment in "Greater China" (includes HK/TWN) of $4.8B as of 9/2024.Image
Included in this $4.8B balance sheet figure are leasehold improvements on Apple Stores, "inventoy prepayments" and owned "capital assets at its suppliers' faciliities" like molds and specialized equipment sitting in Foxconn's factories. Image
Image
Again, the $4.8B represents the cumulative aggregate of long-lived assets that Apple has in China, Hong Kong and Taiwan.

And notably, Apple has been liquidating (a.k.a. converting to cash and repatriating) this tangible asset base.

This number peaked at ~$13B in 2019.Image
Read 13 tweets
Glenn Profile picture
May 7
The whole China-US supply-demand debate is polluted by shoddy economic reasoning and false narrative premises that have led to piss-poor strategy and policy implementation:

▪️ U.S. demand isn't fixed but driven by income (both wage- and capital-related), which is driven by productivity. Lower productivity — whether from trade war-related economic adjustments or retaliatory actions — will negatively impact income, which leads to lower sustainable demand.

▪️ The U.S.-China bilateral goods balance overstates the surplus as it does not account for offsetting deficits that China runs with other countries, the large FDI income and services deficits and other factors. Thus focusing on this metric has led policymakers to seriously overestimate the economic leverage American "demand" has over China.

▪️ Focus on China's "low consumption" has long been a red herring. It is demand — which like the U.S. and or any economy, is driven by income and productivity — that matters in the long run.

▪️ China's "low consumption" is mainly a function of its gross capital formation (GCF) levels being high. GCF is mostly domestic. And people forget GCF is merely a form of deferred consumption: all economic activity (GDP) becomes consumption at some point; "consumption" and "gross capital formation" are merely differentiated by the question of whether it is consumed now or consumed later. This concept might be less confusing if we properly referred to "consumption" in a GDP concept by its more accurate technical name, "household expenditures".

▪️ China's persistent "low consumption" or "low household expenditures" is not a function of debt or institutional "constraints" but policy choice that is largely underpinned by demographics: China's current labor force complements capital-intensive development. And Chinese housing and infrastructure buildout is not close to being complete.

▪️ That said, the former (labor force priority) is changing rapidly, driven by actual demographic change, automation and the trade war, all of which force costly economic adjustments on the economy.

▪️ The trade war-related adjustments lead to productivity boosts in the long run. Offshoring labor-intensive export processing work that dominates Chinese exports to the U.S. is what China needs to do in the long run to become an advanced, high-income fully developed economy.

▪️ Both the U.S. and China need to undertake costly economic adjustments in the short- to medium-term. The "winner" out of the trade war is the one that can (i) more rapidly undertake these adjustments and (ii) make the right adjustments that lead to productivity growth in the long run.
"U.S. demand isn't fixed"

There are many analysts out there — e.g. those who like to use the phrase "supplier of demand" — who seem to rather ignorantly assume that American demand is some constant, magical force without considering the fundamental sources of real demand, which is productivity and global trade ... and how the trade war might impact both of these.

The American economy is highly productive! A key part of productivity growth, particularly over the last three decades, has been the continuous rise of the American MNC, especially in sectors like technology/Internet and pharma.

American MNCs have gone out into the world and absolutely crushed it. Their rise drives the incomes of well-paid employees (mainly located in the U.S.) and capital income in the form of dividends, share buybacks and rising market capitalizations (which support persistent capital inflows).

Rising incomes support rising demand. American MNCs directly and indirectly enable American households to increase their purchases of physical goods from places like China.
The obvious corollary to this is that any relative decline in such a key source of rising American incomes will also correspondingly impact American demand.

For example, if China undertakes retaliatory action against American MNCs operating in China, generating hundreds of billions of dollars of revenue selling to Chinese households (not counted in the trade balance, by the way), then this will impact American income (and demand) in exactly the same way that the Trump tariffs forcing Chinese exporters to make painful adjustments.

American share of global demand would have to decline until American MNCs can find new markets, just like Chinese share of global supply would decline until Chinese exporters adjust their business models.

It's exactly the same, just involving different types of companies and reflected in different categories on the Balance of Payments.
Read 7 tweets
Glenn Profile picture
May 3
Simplest way to think of Huawei is that it has first pick (de facto monopsony) on elite STEM talent from the largest pool of STEM talent in the world and a culture and organizational & incentive structure that can efficiently re-allocate its R&D workforce to new product development adjacencies.

The NBA lottery is coming up so I will use that as an analogy.
From this perspective, it is analogous to a company like Samsung Electronics and TSMC — which hold similar “draft rights” on elite Korean and Taiwanese STEM talent** — but scaled up 20x and 50x, respectively.

** the Korean and Taiwanese equivalents of Cooper Flagg, Ace Bailey, VJ Edgecombe and Dylan Harper …
And in the United States, it is similar with Big Tech.

Companies like Google and Amazon can also expand into new product and service adjacencies because their financial gravity and brand prestige with prospective hires mean they have a disproportionate number of “first round picks” every year.

And on top of homegrown talent, the U.S. has the added benefit of attracting international STEM players through its leading university system.
Read 15 tweets
Glenn Profile picture
Apr 27
China exports ~100M iPhones p.a. to the U.S. currently. This is valued by customs at ~$45B, or ~one-tenth of exports.

China’s economy only makes ~$60 in net GDP per average iPhone 👇 (this one says $72 but this is a high-end iPhone).

So China needs to replace ~$6B of lost GDP, or 0.033% of its annual output. At ~$8/hour, this is ~300k (mostly blue-collar) workers.

Every day, on average China creates ~33k urban jobs (~12M annualized). So losing the iPhone trade amounts to ~9 days of job absorption.

Remember this is ~one-tenth of China’s bilateral exports to the U.S.

So you need to explain to me why China won’t be able to absorb the loss of these relatively low value-add export processing jobs? If anything, it will merely just accelerate its move up the value chain.

Instead of assembling iPhones, China will grab higher market share of higher-value components like chips, memories and OLED screens.Image
Now think about what happens when Apple loses market share, either as a result of retaliatory actions on its China sales or by tariffs rising prices and lowering demand.

Apple sells ~45 million iPhones in China today at ~$900 per unit. It generates ~43% operating margins, or ~$390 per iPhone.

Say Apple loses half its market share in China. ~22M iPhones x $390 operating profit per iPhone = ~$8.5B in lost economic value to Apple / U.S.

Who is hurt more in this exchange?
This market share is most likely absorbed by higher end domestic phone models from Huawei and Xiaomi.

Instead of spending $900 on iPhones (where only $60 of manufacturing value-add accrues to the local economy), Chinese HHs now instead spend the same amount on domestic phones where most of the price supports the Chinese economy.

China effectively swaps low-value add manufacturing value-add with much higher value-add tech and R&D value-add.

I think it’s a trade they would make.

The only downside is the economic adjustment, which is a “one-time” event.
Read 4 tweets
Glenn Profile picture
Apr 24
A decade it was virtually inconceivable that the relationship between the U.S. and EU would splinter so much that it gave China the opportunity to fill the void.

This would be the trade/economic equivalent of the U.S. splitting China off from the Soviet Union in the 70s.
When Xi Jinping makes statements like "the world is in a turbulent time that is unprecedented in the past century" in 2021 he was likely referring to the possibility that situations like this to arise where China is essentially being handed the opportunity to re-shape global affairs much earlier than anticipated.
This is a complete self-own by the United States — in particular, a Trump administration whose crusade against allies and poorly executed implementation of the latest "reciprocal" tariffs are increasingly being perceived as an "Emperor Has No Clothes" moment for the President and the U.S. nation.
Read 5 tweets

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