Is China Really Running a Trade Surplus?

James K. Galbraith
Professor
Lyndon B. Johnson School of Public Affairs
The University of Texas at Austin
Austin, Texas

Sara Hsu
Adjunct Professor of Economics
St. Edwards University
Austin, Texas

Li Jianjun
Professor of Economics
Central University of Finance and Economics
Beijing, China

Last updated: December 30, 2007

The University of Texas Inequality Project

UTIP Working Paper 45

Abstract

We examine China’s macroeconomic and trade accounts for simple, tell-tale signs that capital
inflows are being disguised as export earnings. We find large reported increases in a calculated
unit value of Chinese manufactured exports, which do not appear to correspond to increased unit
prices in the accounts of countries importing from China. We therefore suspect that the
legalization of dollar accounts by firms resident in China, as well as an increase in expectation of
RMB appreciation which occurred in 2003, have led to large disguised capital inflows. The
magnitudes could range up to $529 billion by 2006. If this is correct, then China is not running a
$170 billion current account surplus as officially reported in 2006, but rather a much smaller
surplus, or even a deficit, obscured and financed by illicit inflows.

1
Introduction

One of the most basic principles of international macroeconomics is that the growth of imports
depends on the domestic rate of growth, while that of exports depends on growth in external
markets. For a country selling manufactured goods to the whole world, the relevant comparison
is surely between the national growth rate and that of the world economy, or at least that of the
OECD countries, which provide the lion’s share of the global consumer market.

Thus when a developing country experiences a prolonged period of high growth of internal
demand, it is normal for a trade deficit to emerge. This is especially likely if the country in
question is an importer of food and fuel and commodity prices are rising. And if the country
faces a finance constraint, the trade deficit will ultimately limit the growth surge. Innumerable
cases can be cited, in Latin America, Africa, and even Europe. Exceptions, per contra, are rare,
and in the modern record largely confined to countries that maintain rigorously undervalued
exchange rates and repressed domestic consumption, while rapidly improving the composition
and quality of their exports.

Seen from this perspective, the recent record of the People’s Republic of China is simply
astounding. China has been running reported internal real growth rates of eight percent or so for
three decades, during which time OECD growth rates averaged less than half of that figure (WDI
Online). And while during most of this period China reported small trade surpluses, in the most
recent years China’s current account surplus has exploded. China’s reported exports nearly
quadrupled from 2000 to 2006, from $249 to $969 billion, a rise of nearly three-quarters of a
trillion dollars. Despite the fact that China’s imports rose substantially in both quantity and unit
prices during this period, China reported a trade surplus of over $170 billion in 2006.

But if this feat seems improbable, there is the possibility that it didn’t happen.

In this paper, we show that a very large fraction of the gains in reported Chinese exports after
2002 are apparently due to rapidly rising unit values, following a long period in which unit
export values did not rise at all. Only 40 percent, at most, of the export rise can be attributed
firmly to rising export quantities. The question we pose is: did the per-unit values of Chinese
manufactured exports really rise at rates exceeding 20 percent for three consecutive years?
Looking at import prices for Chinese goods recorded in other countries and similar evidence, we
find no trace of such a transformation in unit prices, and only modest shifts in the composition of
exports that might be raising measured unit values.

That being so, the possibility arises that Chinese exporters have been over-reporting export
prices to the Chinese authorities, for the purpose of bringing foreign exchange into the country.
The incentive to do so stems from two facts: the continued enforcement of strict controls over
capital inflows per se in China, and the legalization, in late 2002, of unlimited foreign currency
accounts held in China by Chinese firms. On the simple evidence of reported price increases, the
disguised capital inflow could be very large: potentially enough to turn that reported surplus of
$170 billion in 2006 into a substantial trade deficit, and enough to explain the very large increase
in the share of fixed investment in Chinese GDP that occurred after 2002.

2
Capital Inflows into China

Hot money has been flowing into and out of China since its emergence as a major economy. And
the Chinese government, which has a long history of capital control, is concerned about the
issue. Since capital controls remain in force in China while the current account was liberalized in
19961, it stands to reason that some efforts to evade capital control would flow through the
current account.

Officials at the People’s Bank of China (PBOC) have confirmed that significant hot money
inflows have run through the current account2 through the over-invoicing of exports, the practice
of overstating export values in order to bring foreign capital into the country. Hu Xiaolian,
director of the State Administration of Foreign Exchange (SAFE), and vice governor of the
PBOC, and Deng Xianhong, deputy head of SAFE, recently called for audits of short-term
foreign exchange accounts to check these inflows (Xin 2007)3. An anonymous governor of
PBOC, associated with the National Development and Reform Commission (NDRC), has
estimated that "false exports during August-December 2006 resulted in an increase of US $17.5
billion in the favorable foreign trade balance, accounting for 17% of the total favorable balance”
(Zhong 2007).4 It appears that the Chinese government has estimated the occurrence and extent
of capital inflows in the trade account by watching short-term foreign exchange transactions,
upon which the PBOC imposed further regulations in February of 20075,

Scholars and bank economists have long watched Chinese hot money fluctuations, mainly via the
catch-all errors and omissions category in the balance of payments (Prasad and Wei 2005).
Green (2006) estimates that hot money inflows comprised US $67 billion in 2005, although this
is a very rough estimate. Some have also suspected that hot money has also flowed into the
current account, taking the form of payments for fictitious exports or over-invoicing of actual
exports. This phenomenon appears not to have attracted extensive scrutiny so far.6 Yet, it could
have large implications for understanding the true trade and financial position of China today

In this paper, we investigate the extent to which capital inflows may have appeared deceptively
in the trade account from 2003 to 2006. Not having access to the Chinese government’s
financial data, we take a simple alternative approach: we estimate the inflows using the
published balance of payments data, while checking our estimates against investment, foreign
import prices, and financial activity.

1
See Li (2004). “Capital Account Liberalization in China,” The Chinese Economy, 37(1), pp. 85-116 for a timeline
of current account liberalization.
2
Wei and Zhang (2007) note that a government official of an “anonymous” country admits that capital inflows have
been introduced through the overbilling of exports. That the reference is to China is consistent with the context of
this remark.
3
Nineteen domestic banks and ten international banks have been punished for facilitating short-term money inflows
disguised as trade or investment (Anderlini, Financial Times, June 27, 2007).
4
On the other hand, Sun Mingchun, vice-president and Asia economist of Lehman Brothers Asia Ltd, stated that hot
money inflows may be slowing down due to recently implemented checks on short-term capital inflows and stock
market transactions (Zhang July 13, 2007).
5
See People’s Bank of China Adjusted Foreign Exchange Administration Policy towards Individuals
6
Gunter (2003) makes a case for the phenomenon of capital flight from China, from 1984 to 2001, with over-
invoicing of imports.

3
China’s unlikely export values

A simple first cut at the problem involves making a large, problematic assumption: that changes in the
internal composition of Chinese exports within major product categories over a short three-year period
can be safely ignored. (We will examine this assumption in detail later.) If we can treat the commodity
composition within the major product categories as fixed, then dividing total export values by quantities
will give us a “unit value” measure of Chinese exports.

The official data available for this purpose are very erratic, but it is easy to show that this is due
mainly to the influence of two highly volatile export sectors, neither of which is quantitatively
very important7. We therefore construct a streamlined representation of export volume by
removing those sectors. For the remaining sectors, we find a steady increase in export volumes
over time. Dividing dollar volume by these quantities gives unit values8. We calculate unit
values using both OECD and CEIC data, applying the growth rate in calculated unit values after
2004 to quantities given in the OECD data9.

Table One shows export unit values from 1996 to 2006 calculated after excluding the volatile
sectors10. In manufacturing, these values are extremely stable through 2002, at around $0.39
USD per reported unit, and then they start increasing rapidly. In 2003, the manufacturing export
unit value jumps to $0.49, and in 2004, to $0.59. In 2005, the export unit value is $0.72, peaking
at $0.97 in 2006, and the overall export unit value follows the same trend, which is not surprising
since manufactures dominate Chinese exports.

Table One: Export Unit Value (In US Dollars)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Export Unit
Value (Our
Calculations) 0.51 0.47 0.47 0.46 0.46 0.45 0.46 0.56 0.66 0.79 1.00
Export Unit
Value (Official
Statistics) 0.05 0.06 0.07 0.08 0.10 0.08 0.60 0.70 0.76 N/A N/A
Manufacturing
Export Unit
Value (Our
Calculations) 0.40 0.38 0.39 0.39 0.39 0.38 0.40 0.49 0.59 0.72 0.97

7
See Table Five below. The volatile sectors are Beverages and Tobacco (SITC 1) and the Special Commodities and
Transactions (SITC 9)
8
This calculation is far from precise, because quantities are organized by type of unit, such as tons, thousands of
units, and so forth, depending on sector, so there is no single consistent “unit of exports.” For this first cut, we are in
effect assuming the existence of a constant “composite unit,” not strongly affected by changes in the composition of
exports or by quality change.
9
OECD data is the only data set that contains total quantities for SITC categories and for all trade, but only goes up
to 2004. CEIC makes some quantities available, but not all. Therefore, we needed to use both.
10
The World Bank’s WDI Online database includes information on China’s export value indices. These are also
shown to increase dramatically from 2003 to 2006. We choose not to use this information because data from
another source, UN Comtrade, do not show the same increase.

4
 Source: OECD and CEIC Data and authors’ calculations11

Now, let us suppose that Chinese exports had continued at unchanged unit values for the entire
period from 1997 through 2006. What would have been the growth of total exports on that
assumption? Table Two gives actual export values, export values under the counterfactual of no
unit value change, and the difference, which is attributable to changing unit values. It is clear
that a major part of the reported increase in Chinese exports is not due to increasing raw
volumes, but rather to some combination of reported price increases and product transformation,
reported as rising unit value.

Table Two: Export Volumes and Total Exports Attributable to Volume Gain
(in Billions of Current US Dollars)
Exports of
Goods and
Exports of Services at
Goods and Unchanged Unit
Services Values Difference12
2002 365.4 365.4 0
2003 485.0 398.4 86.6
2004 655.8 457.1 198.7
2005 836.9 490.2 346.7
2006 981.0 452.4 528.6

Source: World Bank WDI and authors’ calculations

As noted, part of the increase in unit values can be attributed to actual price increases in exports,
and part to shifts in the composition of Chinese manufacturing output to higher technology
goods. But how much? That is the question we next examine.

Have Chinese manufactured exports increased in unit price, that is, in value per item holding
composition and quality constant? If they had, we would expect that the unit import prices in
manufactured goods reported by other countries, especially Europe, Japan and the United States,
would show comparable increases. However, as Tables 16 to 18 in the appendix demonstrate,

11
Rather than using given total quantities, the total of the individual commodity categories (minus the extremely
volatile beverages and tobacco category) was used, since the two were not equal. Using given total quantities would
result in an even more dramatic increase in value per exported unit. The OECD does not yet have data for 2005-6.
We therefore estimated this using quantities and values calculated from CEIC data, adding up quantities and values
for all categories that had quantities, and finding the unit value. We then looked at the growth rate of the CEIC unit
values and applied this to CEIC data. The growth rate and unit value for 2004 was consistent with OECD data,
providing an overlap in data sets.
12
We calculated “hot money” inflows assuming they started in 2003. Therefore, we find that the difference in 2002
is zero.

5
there is no sign of this at all. Every table shows stable or declining unit prices, and in some cases
sharply declining unit prices, for manufactured imports. Eurostat even publishes unit price
indexes specific to imports from China; these show no net change for manufacturing or
machinery, the major Chinese export sectors.

Further, if Chinese exporters had simply raised the prices of goods sold to the world market, we
would expect to see a loss of market share. Manufactured goods together total nearly 90 percent
of Chinese exports by value, and it seems unlikely that their prices could rise sharply without
significant losses in favor of Vietnam, Malaysia and other low-wage competitors. In fact, there
were no significant losses toward competing exporters. To the contrary, the quantity measures in
manufacturing show robust growth in 2003 through 2006. In the case of commodity-based
exports, such as animal and vegetable oils and fats, price increases could have happened without
loss of market share, insofar as overall commodity prices rose during this period. But such
goods are a trivial share of total Chinese exports by both value and quantity.

Table Three shows the ASEAN share of world markets over this period: there is no sign of an
increase that could be attributed to Chinese exporters pricing themselves out of the market.

Table Three: ASEAN Share in World Exports13

(Percentages)

1998 1999 2000 2001 2002 2003 2004 2005

ASEAN Share
in World
Exports 4.8% 5.1% 5.6% 5.2% 5.2% 4.0% 5.4% 5.4%

Source: UNCTAD Statistics Database

A second possibility is that China has upgraded the actual quality of its exports, justifying higher
unit values not with price increases but with better goods. This possibility is particularly relevant
to the processing trade, where China could be importing increasingly high-value goods in order
to finish them and export them again. But if this were the case, then unit values of Chinese
imports in manufacturing would also be increasing. Table Four gives unit values for imports in
manufactures and machinery; no unusual increase is observed, although there appears to be a
steady slight progression in unit price from 2001 onward. This may account for part of the
export unit price increase, but not too much of it. This share of the unit value increases could be
due to an increase in the technological content of process-trade goods, which did occur starting
in 2002. However, the fact that the unit value increase is not reflected in Chinese import unit
value increases (Table Four) leads us to infer that changes in the composition and degree of the

13
Also according to the UNCTAD Statistics Database, the share in world manufacturing exports for Eastern,
Southern, and Southeastern Asia excluding China was 16% in 1995, 20% in 2000 and 23% in 2005.

6
processing trade do not account for the entire unit value increase and perhaps not even for very
much of it. Note that the report unit value for manufacturing in 2004 is only 13 percent higher
than its 1998 value, while export unit value is up over 50 percent. This would suggest that
around three-quarters of the excess increase in export unit value cannot have been contributed by
increased unit values in semi-processed imports, even if the processing trade were all of China’s
manufactured exports, which it is not.

Table Four: Import Unit Values (into China)

(in USD)

1996 1997 1998 1999 2000 2001 2002 2003 2004

Import Unit Values 0.47 0.38 0.38 0.36 0.36 0.38 0.38 0.43 0.45
Manufacturing
Import Unit Values 0.74 0.52 0.54 0.47 0.43 0.52 0.55 0.59 0.61

Source: OECD Data and authors’ calculations

The next issue is, to what extent did the composition of Chinese exports across broad industrial
sectors change? Had the sharp rise in the per-unit value of Chinese exports been the result of a
sudden shift in the composition of exports, such shifts would be observed in the data at the level
of broad SITC categories. There is in fact an increase of about three percentage points per year in
the export share of the machinery and transport equipment sector, but this increase has been
going on for a long time, and the gains after 2003 are not out of line with past experience.
Otherwise, the sectoral composition of Chinese exports over time appears substantially stable.
Processing trade in particular remained steady in percentage of overall exports, at 55% per year
from 2000 through 2005, according to the Ministry of Finance14.

In the reported data, the surge in dollar value per unit of exports since 2003 originates in the
manufacturing sector. Of the total dollar value per unit of all exports in 2004, or $0.66, $0.11 is
from the manufactured goods sector, $0.30 is from the machinery and transport equipment
sector, and $0.18 is from the miscellaneous manufactured goods sector. Table Five illustrates
the patterns of per unit value change across sectors.

14
http://www.mofcom.gov.cn/tongjiziliao/tongjiziliao.html

7
 Table Five: Sector Unit Value Representation in Total Dollar Value per Exported Unit, by SITC Code

(in US Dollars)

3 4
2 Mineral Animal 5
Crude fuels, and Chemicals 7
0 materials, lubricants vegetable and Machinery 8 M
Food inedible, and oils, fats related 6 and iscellaneous
Total and live except related and products, Manufactured transport manufactured
trade animals fuels materials waxes n.e.s. goods equipment articles
1994 0.51 0.04 0.02 0.02 0.00 0.03 0.10 0.09 0.21
1995 0.52 0.04 0.02 0.02 0.00 0.03 0.11 0.11 0.19
1996 0.51 0.03 0.01 0.02 0.00 0.03 0.10 0.12 0.19
1997 0.47 0.03 0.01 0.02 0.00 0.03 0.09 0.11 0.18
1998 0.47 0.03 0.01 0.01 0.00 0.03 0.08 0.13 0.18
1999 0.46 0.02 0.01 0.01 0.00 0.02 0.08 0.14 0.17
2000 0.46 0.02 0.01 0.01 0.00 0.02 0.08 0.15 0.16
2001 0.45 0.02 0.01 0.01 0.00 0.02 0.07 0.16 0.15
2002 0.46 0.02 0.01 0.01 0.00 0.02 0.08 0.18 0.14
2003 0.56 0.02 0.01 0.01 0.00 0.03 0.09 0.24 0.16
2004 0.66 0.02 0.01 0.02 0.00 0.03 0.11 0.30 0.18

Source: OECD Data and authors’ calculations

Further, the change in unit export values does not reflect or correspond to any large increase in
the wage bill. This can be seen in Table Six, which illustrates wages per unit output. We do not
see a marked decrease in this ratio, which would have indicated that a price increase is related to
a sudden increase in wage claims. Rather, wage costs appear to hold steady from 1997 onward.

Table Six: Wage to Output Ratio

(in Percentages)
Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Wage
Bill 13% 12% 11% 11% 11% 11% 11% 11% 11% 11% 11%

Source: China Data Center and authors’ calculations

The final issue is, to what degree could shifts in the composition of Chinese exports across
narrowly defined (three-digit) industrial categories within manufacturing account for the
apparent rise in unit values? Table Twenty-Two in the appendix reports the results of a
disaggregation exercise, aimed at isolating those categories with the largest increase in export

8
share due to apparent changes in unit value. We find that compositional shifts do occur, but they
do not appear to be very large in relation to the overall increase in reported unit value. And their
interpretation is ambiguous. Interestingly, the largest changes are substantially concentrated in
capital goods sectors such as machinery and equipment – precisely those sectors where quality
changes, quantity increases and disguised capital inflows would be hardest to disentangle. We
are left with no clear resolution on this topic, While it is possible that China suddenly and
rapidly upgraded the quality of its machinery exports after 2002, it is also possible that those
seeking to disguise capital inflow would tend to choose these same sectors as being the safest
channel for such activity. Detailed forensic work, case studies of technical change in the relevant
sectors, and insider accounts would appear to be necessary to resolve the issue.
We infer that China’s export figures overall, as well as in the important manufacturing sectors,
are very probably overstated. By how much?
We now examine the extent to which funds may have entered China via this illicit route. A clue
to the phenomenon at hand may possibly be found in the percentage change in gross capital
formation (Table Seven). This figure increases sharply in the post 2002 years. This is the result
of an enormous increase in the construction of fixed assets such as plant and equipment, offices
and housing.
Table Seven: Gross Capital Formation
(In Current US Dollars or Percentages where indicated)

Percentage Percentage
change in change in
gross capital gross capital
Gross capital Percentage formation formation
formation change in adjusted for adjusted for
GDP (billions (billions of gross capital min hot max hot
of current US$) current US$) formation money inflows money inflows
1996 856.1 346.2
1997 952.7 361.5 4% 4% 4%
1998 1,019.5 378.2 5% 5% 5%
1999 1,083.3 398.0 5% 5% 5%
2000 1,198.5 420.9 6% 6% 6%
2001 1,324.8 480.5 14% 14% 14%
2002 1,453.8 550.5 15% 15% 15%
2003 1,641.0 676.1 23% 18% 7%
2004 1,931.7 835.7 24% 19% 8%
2005 2,243.9 971.0 16% 12% -2%
2006 2,668.1 1,085.8 12% 7% -11%

9
 Source: WDI and authors’ calculations

The increase in gross capital formation reflects, in other words, the construction boom that is
everywhere visible in urban China. Gross capital formation increased by more than 60
percentage points from 2003 to 2006. What is more, to take a specific instance, the Beijing real
estate industry operating income and profit moves sharply from negative to positive numbers in
2003, a dramatic increase. This is a very significant change.

Table Eight: Beijing Real Estate Statistics

(in Million Yuan)

Real Estate Industry Real Estate Industry Investment in Commercial

Operating Income Total Profits Office Buildings Buildings Sold
2000 -1862 -1303 4521.9 424.84
2001 -1046 -215.3 7199.3 1245.8
2002 -1026 -587.1 9732.6 2595.3
2003 895.9 1743.3 14275 5177.9
2004 8661.1 10701 18789 5883.4
2005 6184.4 8131 19617 12085
2006 11053 14959 21674 16256

Source: CEIC

The question, then, is: how much of this increase might be accounted for by capital inflow?

We believe the answer could be: much of it. If we assume, conservatively, that 30% of the
increase in export unit value is due to disguised capital inflows, we find that China is running a
much smaller trade surplus. In this case, we estimate that the total disguised capital inflows into
the export account were USD $23 billion in 2003, $54 billion in 2004, $95 billion in 2005, and
$157 billion in 2006. This accounts for much of the rise in fixed investments as a share of GDP
that had occurred up to that point. At the other extreme, based in part on unit price indices
reported by importers of Chinese manufactures, it would not be unreasonable to argue that there
was no increase in real unit export values after 2002. The disguised capital inflows would
amount to $87 billion in 2003, $199 billion in 2004, $347 billion in 2005 and $529 billion in
2006. In that case, China’s 2006 “actual” current account deficit would amount to $425 billion,
and the cumulative deficit since 2003, disguised by capital inflow, would amount to $847 billion.

10
 Table Nine: Capital inflows under varying assumptions of unit value increase

(in USD)

Percentage of
Increase from
2002 2003 2004 2005 2006
30% 26.0 59.6 104.0. 158.6
60% 52.0 119.2 208.0 317.2
90% 77.9 178.9 312.1 475.8
100% 86.6 198.7 346.7 528.6

Source: OECD, WDI and CEIC Data and authors’ calculations

Table Ten: Effect of estimated capital inflows disguised as current account on Balance of Trade
(in Current billions of US Dollars)

Balance of
Balance of Trade
Trade Adjusted
Adjusted for
Exports of for Maximum
Goods and Minimum Value
Services Difference Value (100%) of
Exports of Minus Hot (Max Hot Imports of (30%) of Hot Money
Goods and Money Money Goods and Balance of Hot Money Inflows
Services Inflows Inflows) Services Trade Inflows
1998 207 207 0 164 44 44 44
1999 221 221 0 190, 31 31 31
2000 280 280 0 251 29 29 29
2001 299 299 0 271 28 28 28
2002 365 365 0 328 37 37 37
2003 485 398 87 449 36 10 -51
2004 656 457 199 607 49 -10 -149
2005 837 490 347 712 125 21 -222
2006 981 452 529 878 103 -55 -425

Source: WDI and authors’ calculations

11
Caveats and Qualifications

The assumptions used in our calculations are subject to several qualifications and reservations.
First, we assumed that growth in unit value data from the CEIC database is transferable to OECD
data. Since SITC category and overall quantity totals are not given in the CEIC database (only
subcategory values are available), the translation may not be entirely accurate for 2005-6. When
we asked the OECD statistics division why sub-category totals were smaller than SITC category
and overall totals, they replied that this was due to “confidential reasons” on the part of the
Chinese government. We incorporated only values and quantities for CEIC categories that had
both types of data available, and believe that this may underestimate the unit value increases.
Therefore, on this account, we erred on the side of understating capital inflows.

Second, there are issues with Chinese reported statistics as noted in other literature. There are
problems with GDP, particularly with the overstatement of GDP for political purposes, as well as
problems with trade statistics, due to Hong Kong re-exports16. Although this is problematic in
determining exact numbers, the phenomenon of inflated export figures is more or less traceable
since the last major shift in statistics occurred in 1998, when the National Bureau of Statistics
began to use sample survey estimates of small scale industry, affecting the calculation of GDP
(Naughton 2007, p. 141). A smaller shift in statistical classification has occurred in the past few
years, when several export categories were broken into sub-categories, while some were
discontinued. However, this did not affect trade statistics within the larger SITC categories. .

Changes in the Financial Environment

Assuming that China has, in fact, experienced major capital inflow disguised as export earnings,
why did it happen? In part, we believe, because changes in China’s regulatory environment
made it possible.

In 2003, there were several changes in China’s financial sector which made the environment
more favorable to capital inflows. The interest rate began to look more attractive vis-à-vis the
dollar, while the NDF premium began to decrease, indicating expectations of yuan appreciation
against the dollar. Tables Eleven and Twelve illustrate these trends.

16Green writes that the US exaggerates value-added in Hong Kong as around 25% of China’s
goods value, while China tends to understate these values. He believes the US-China deficit
may be the average of the two records. In any case, China’s understatement of Hong Kong re-
exports has not changed over time, so does not affect the general unit value trend.

12
 Table Eleven: RMB Less Dollar Yields
(In Basis Points)

1998 1999 2000 2001 2002 2003 2004 2005 2006

Avg 3-month
Chinese
Repo less US
Treasury 1.96 -1.17 -3.4 -0.83 0.54 1.59 1.35 -1.44 -2.41
Avg 3-month
CHIBOR
less USD
LIBOR 2.23 0.95 -2.46 0.03 1.6 1.66 1.71 -0.77 -2.57

Source: CEIC, US Treasury Statistics, British Bankers Association

Table Twelve: Non-Deliverable Forward Premium

(Percentage of Spot)

Source: Ma and McCauley (2007, p. 16)

13
The rise in unit export values also occurred in conjunction with an important change in the rules
governing the holding of dollars inside China. In October 2002, the central government gave
permission for all companies to hold foreign exchange accounts. Controls over foreign exchange
purchases were relaxed for many businesses, including exporters, while the ability to open
foreign exchange accounts was extended to firms outside bonded zones (Lehmanbrown.com,
2002). The goal of this measure was to liberalize the current account, facilitating trade and
reducing the state presence in credit markets. Not surprisingly, we see, in Table Thirteen, that
foreign exchange transactions within China increased tremendously beginning in 2003.

Table Thirteen: Foreign Exchange Transactions within China

(in 100 Million Units)

Overall USD HKD JPY EURO

Turnover Trading Trading Trading Trading
(in USD) Volume Volume Volume Volume

2001 750.3 741.3 30.6 613.9 N/A

2002 971.9 951.1 108.8 730.8 1.1
2003 1511.3 1478.2 186.3 761.6 3.0
2004 2090.4 2044.1 244.9 1349.6 1.9

Source: People’s Bank of China

Thus, the regulatory and investment environment was ripe for injecting capital inflows into
China. Using the trade account to bring in capital was relatively simple over this period.
Exporting companies simply had to overbill exports, and foreign exchange could be transferred
into the companies’ bank accounts.

The recent crackdown on short-term foreign exchange accounts, and the punishment of both
foreign and domestic banks for the violation of exchanging currency outside of controls, has
revealed how loose controls over foreign exchange accounts had become. Further evidence
comes from the recent exposure and punishment of a large underground bank headquartered in
Shenzhen, which exchanged foreign currency and maintained foreign exchange accounts. All of
these measures are attempts by the central government to curb hot money inflows and illegal
foreign exchange transactions, in order to maintain better control over the current account17.
Based on CEIC data available thus far this year, the unit value of exports has virtually ended its
upward movement, and perhaps the disguised inflow of capital has now come to an end.

Part of the increase, too, may stem from over-billing exports to receive additional Value-Added
Tax 18(VAT) rebates after the January 2002 legislation loosened restrictions over VAT rebates.
However, in our calculation, we do not see a large unit price increase for the year 2002, which
would indicate that VAT abuses due to the legislation have not been very large.

17
In addition, the real appreciation of the renminbi in terms of the dollar in December 2006 signals a change in the
desirability of purchasing RMB with dollars.
18
VAT rates range from 5-17%. The standard VAT rate is 17%.

14
What is more, accession to the World Trade Organization affected the trade climate after 2001,
but the process of trade and capital control reform continued to be gradual. We believe, then,
that much of the export unit price increase is due to overstated values that hide hot money
inflows into China’s real estate and other asset markets.

Implications of capital inflow via China’s trade account

It appears that China ran a true current account surplus much smaller than reported, and may
have actually run a trade deficit from 2003 to 2006. This conclusion depends in part on an
assumption that China’s import statistics are accurate. Though in the past the over-invoicing of
imports may have served to mask capital outflow from China, we have seen no evidence to
suggest similar distortions in China’s import accounts at the present time. Indeed there would be
little reason for it: hot money flows where markets are hot, as they unquestionably have been in
China, and where a currency is widely expected to appreciate. This too was the Chinese case.

There are several implications of large net capital inflows disguised as exports. At a glance, trade
statistics, and any calculations which use export or net export values, will require correction19.
This includes both GDP and the growth rate, figures envied by most other developed and
developing nations alike. Also suspect are the recent large profit increases reported by many
Chinese firms, which could be an artifact of laundering exaggerated export earnings.

Given that we find a much smaller current account surplus, or even a deficit, repeated calls by
the United States for appreciation of the RMB based on evidence of an exploding trade surplus
lose force. An appreciation of the RMB would increase the exchange value of the hot money
invested in China from 2003 to 2006, and the most interested parties may be speculators –
including some with political connections in the United States -- who have engaged in illicit
investment in China through fictitious trade. This reduces much of the demand for RMB
appreciation to an interest in validating a currency speculation.

The nature of China’s external financial balance would also change. As an investment on behalf
of foreign interests, capital inflow places foreign claims on domestic assets. Although Chinese
domestic savings and investment are high relative to other countries, domestic savings and
investment will be seen as much lower than they have seemed, while foreign investment will be
seen as much higher, once capital inflows through trade are correctly accounted for,

Conclusion

We believe that simple macroeconomic evidence points quite strongly to a significant

overstatement of China’s exports, masking an equivalent capital inflow. This inflow is
potentially large enough to put China’s actual current account into deficit, greatly weakening the
case for appreciation of the RMB. It also suggests that other aspects of the widely-held view of
recent Chinese economic performance, including the profits boom in Chinese enterprises and the
growth rate of the economy overall, should perhaps be re-examined for evidence of the role of
capital inflow in distorting both the statistics and the underlying economy.

19
Some studies have shown that China’s GDP statistics are overstated for reasons other than errors in the trade
account. The overstatement has taken place because some firm managers exaggerate output.

15
References

1. Anderlini, Jamil. “China Hits Out Over ‘Hot Money,’” Financial Times, June 27, 2007.
2. Chinadaily.com. May 19, 2004, http://www.chinadaily.com.cn/english/doc/2004-
05/19/content_332004.htm
3. Glick, Reuven and Hutchison, Michael. “Capital Controls and Exchange Rate Instability
in Developing Economies,” Pacific Basin Working Paper Series, Center for Pacific Basin
Monetary and Economic Studies, Economic Research Department, Federal Reserve Bank
of San Francisco, 2000.
4. Green, Stephen. On the Ground in Asia, Standard Chartered Bank, Shanghai, April 13,
2006.
5. Green, Stephen. On the Ground in Asia, Standard Chartered Bank, Shanghai, May 17,
2007
6. Lehmanbrown.com, 2002. http://www.lehmanbrown.com/FAQ/FAQ-Forex/2.htm
7. Ma, Guonan and Robert N. McCauley. “Do China’s Capital Controls Still Bind?
Implications for Monetary Autonomy and Capital Liberalization,” BIS Working Paper
No. 233, www.bis.org.
8. Naughton, Barry. “An Economic Bubble? Chinese Policy Adapts to Rapidly Changing
Conditions, ” China Leadership Monitor, No. 9, 2003.
9. Naughton, Barry. The Chinese Economy, MIT Press: Cambridge, MA 2007.
10. People’s Bank of China. “People’s Bank of China Adjusted Foreign Exchange
Administration Policy towards Individuals,” January 23, 2007,
http://www.pbc.gov.cn/english//detail.asp?col=6400&ID=791.
11. Prasad, Eswar and Wei, Shang-Jin. “The Chinese Approach to Capital Inflows: Patterns
and Possible Explanations,” IMF Working Paper, 2005.
12. Setser, Brad and Rosenblatt, Casson. RGE China Reserve Watch, February 2006.
13. Wei, Shang-Jin and Zhang, Zhiwei. “Collateral Damage: Exchange Controls and
International Trade,” NBER Working Paper No. 13020, April 2007.
14. World Bank. World Development Indicators Online.
15. Xin, Zhiming. “Inflows of Hot Money to be Curbed,” chinadaily, June 27, 2007,
http://www.chinadaily.com.cn/china/2007-06/27/content_903359.htm.
16. Zhang, Ran. “Hot Money Influx is ‘Cooling Down,” July 13, 2007,
http://www.chinadaily.com.cn/china/2007-07/13/content_5433984.htm.
17. Zhong, Weike. “Control of Exports,” China Chemical Reporter, June 16, 2007,
http://goliath.ecnext.com/coms2/summary_0199-6672809_ITM.

16
 Appendix

Table Fourteen: Change in Unit Price, Year on Year, by Sector

(in Percentages)

3 4
2 Mineral Animal 5
Crude fuels, and Chemicals 7
0 materials, lubricants vegetable and Machinery 8
Food inedible, and oils, fats related 6 and Miscellaneous
Total and live except related and products, Manufactured transport manufactured
trade animals fuels materials waxes n.e.s. goods equipment articles
1995 3% -17% -11% 10% -23% 22% 17% 20% -8%
1996 -3% -2% -12% 6% -21% -7% -16% 7% -1%
1997 -7% -17% -20% -10% 32% -12% -7% -5% -4%
1998 1% -4% -16% -26% -52% 1% -5% 15% 0%
1999 -2% -9% 2% -17% -61% -8% -6% 8% -5%
2000 0% -8% -11% 32% -31% -9% 0% 10% -7%
2001 -3% -5% -15% -2% -13% 1% -6% 5% -8%
2002 3% -4% -12% -16% -26% -4% 1% 12% -3%
2003 21% 8% 3% 18% 6% 15% 17% 33% 12%
2004 18% -6% 2% 14% 12% 18% 28% 25% 9%

Source: OECD Data and authors’ calculations

Table Fifteen: Export Unit Values of ASEAN Countries20

(in US Dollars)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Indonesia 109 104 81 65 100 90 96 103 120 81
Philippines 146 134 105 121 100 84 77 79 77 N/A
Singapore 120 112 97 96 100 93 91 90 93 96
Thailand 127 122 107 102 100 102 97 105 118 130

Source: UN Comtrade Yearbook 2005

20
We show all available values for ASEAN countries.

17
 Table Sixteen: U.S Import Price Indices (from World21) by Commodity Category

Mineral Com-
Crude fuels, Chemicals modities
Food materials, lubricants and Machinery Misc. and
and Beverages inedible, and related Manu- and manu- tran-
live and except related products, factured transport factured sactions,
animals tobacco fuels materials n.e.s. goods equipment articles n.e.s.
1991 96 86 82 63 96 91 105 98
1992 93 87 86 60 97 90 106 100 122
1993 95 87 91 48 96 90 108 101 136
1994 111 88 102 56 104 98 110 102 137
1995 105 91 111 59 106 104 112 104 138
1996 103 93 106 80 105 98 110 103 133
1997 108 97 103 61 101 99 105 103 110
1998 103 98 92 38 97 94 102 101 105
1999 103 100 101 83 98 97 100 101 104
2000 100 101 97 106 101 100 99 100 95
2001 95 103 90 61 97 92 98 99 99
2002 99 103 95 95 98 94 96 99 114
2003 101 104 108 108 101 98 95 100 139
2004 112 107 126 141 110 110 95 101 157
2005 117 109 134 202 115 114 94 101 171

Source: BLS Data22

21
Statistics on US imports from China exist (they are collected by BLS) but begin only in 2004, which is
insufficient for our purposes, but even then they show that since 2004, the import price index from China to the US
has held steady or is slightly declining.
22
Category 4 was not available, and Category 971 out of 9 was the only available category. Also, some months
were missing, so we used data from month 12.

18
 Table Seventeen: EU15 Unit Value Index (2000 = 100), Imports from China (excl HK)
Food
and Mineral Animal
live Crude fuels, and Chemical
animals materials, lubricants vegetable s and Machinery Misc.
chiefly Beverag inedible and oils, fats related Manu- and manu- Total -
for es and except related and products, factured transport factured All
food tobacco fuels materials waxes n.e.s. goods equipment articles products
1995 88 67 81 87 82 99 87 92 77 83
1996 92 75 85 96 99 101 89 92 81 86
1997 97 94 93 103 119 103 95 95 89 93
1998 96 97 94 102 125 98 92 91 88 90
1999 96 96 90 92 105 94 89 90 88 89
2000 100 100 100 100 100 100 100 100 100 100
2001 100 100 103 127 98 99 101 100 99 100
2002 98 92 91 112 83 91 94 97 93 95
2003 87 83 84 127 78 82 84 88 82 85
2004 82 75 90 261 84 78 83 88 78 84
2005 85 75 97 217 94 82 85 88 79 84
2006 94 77 97 187 90 83 89 89 85 88

Source: Eurostat Online and authors’ calculations23

23
Yearly data was calculated by averaging monthly data

19
 Table Eighteen: Japanese Imports from World, Unit Price Index on Yen Basis,
(2000 average=100)

Wood,
Metals lumber
All Foodstuffs & & Petroleum, Chemicals Machinery
com- & related related coal & & related & Other
modities feedstuffs Textiles products products natural gas products equipment goods
1991 118 122 116 125 110 99 103 143 116
1992 111 120 110 114 115 88 94 139 110
1993 100 109 98 93 141 73 90 125 100
1994 94 107 99 95 125 62 95 117 97
1995 94 106 98 100 117 63 104 110 100
1996 103 119 106 102 131 80 102 115 107
1997 111 123 113 112 133 92 111 119 113
1998 105 123 118 108 111 73 108 122 117
1999 96 108 107 94 107 71 98 108 105
2000 100 100 100 100 100 100 100 100 100
2001 102 110 103 101 104 107 105 97 106
2002 101 113 103 100 107 105 105 93 107
2003 100 116 100 102 104 112 110 85 103
2004 104 124 99 125 111 124 115 80 104
2005 118 127 100 153 113 172 124 78 109
2006 137 135 105 216 132 216 139 81 120

Source: Statistics Bureau, Ministry of Internal Affairs, Japan and authors’ calculations24

24
Yearly data was calculated by averaging monthly data

20
 Table Nineteen: Change in Unit Quantity, Year on Year, by Sector
(in Percentages)

3 4
2 Mineral Animal 5
Crude fuels, and Chemicals 7
0 materials, lubricants vegetable and Machinery 8
Food inedible, and oils, fats related 6 and Miscellaneous
Total and live except related and products, Manufactured transport manufactured
trade animals fuels materials waxes n.e.s. goods equipment articles
1995 19% -56% 0% 22% -20% 26% 79% 25% 13%
1996 5% 8% -7% -1% -7% 0% -15% 13% 53%
1997 30% 65% 17% 18% 71% 19% 17% 26% 70%
1998 0% 3% -9% -3% -58% -4% -22% 17% 2%
1999 9% -2% -7% -1% -63% 16% -9% 29% 8%
2000 27% 45% 30% 35% 9% 19% 32% 31% 11%
2001 10% -16% 35% 35% 15% 16% -1% 2% 2%
2002 19% 40% 46% -5% -19% 10% 14% 30% 17%
2003 11% 29% -31% 10% -29% 32% 19% 18% 16%
2004 14% -42% -1% -10% 15% 22% 37% 32% 9%

Source: OECD Data and authors’ calculations

21
 Table Twenty: Change in Total Reported Value by Sector
(in Percentages)

1996 1997 1998 1999 2000 2001 2002 2003 2004

Total trade 2% 21% 1% 6% 28% 7% 22% 35% 35%
0 Food and
live animals 3% 8% -4% -1% 17% 4% 14% 20% 8%
1 Beverages
and tobacco -2% -22% -7% -21% -3% 17% 13% 4% 19%

2 Crude
materials,
inedible,
except fuels -7% 4% -16% 11% 14% -6% 6% 14% 16%
3 Mineral
fuels,
lubricants and
related
materials 11% 18% -26% -10% 69% 7% 0% 32% 30%

4 Animal and
vegetable oils,
fats and waxes -17% 72% -53% -57% -12% -4% -12% 18% 29%
5 Chemicals
and related
products, n.e.s. -2% 15% 1% 1% 17% 10% 15% 28% 35%
6
Manufactured
goods -12% 21% -6% 2% 28% 3% 21% 30% 46%
7 Machinery
and transport
equipment 12% 24% 15% 17% 40% 15% 34% 48% 43%

8 Misc
manufactured
articles 4% 25% 0% 3% 19% 1% 16% 25% 24%

9
Commodities
and
transactions,
n.e.s. -46% 93% -98% 3022% 154% 18% 15% 49% -14%

Source: OECD Data and authors’ calculations

22
 Table Twenty-One: Share in Value of Total Trade, by Sector
(in Percentages)

1996 1997 1998 1999 2000 2001 2002 2003 2004

0 Food and live animals 7% 6% 6% 5% 5% 5% 4% 4% 3%
1 Beverages and
tobacco 1% 1% 1% 0% 0% 0% 0% 0% 0%
2 Crude materials,
inedible, except fuels 3% 2% 2% 2% 2% 2% 1% 1% 1%
3 Mineral fuels,
lubricants and related
materials 4% 4% 3% 2% 3% 3% 3% 3% 2%
4 Animal and vegetable
oils, fats and waxes 0% 0% 0% 0% 0% 0% 0% 0% 0%
5 Chemicals and related
products, n.e.s. 6% 6% 6% 5% 5% 5% 5% 4% 4%
6 Manufactured goods 19% 19% 18% 17% 17% 16% 16% 16% 17%
7 Machinery and
transport equipment 23% 24% 27% 30% 33% 36% 39% 43% 45%
8 Miscellaneous
manufactured articles 37% 38% 38% 37% 35% 33% 31% 29% 26%
9 Commodities and
transactions, n.e.s. 0% 0% 0% 0% 0% 0% 0% 0% 0%

Source: OECD Data and authors’ calculations

23
 Table Twenty-Two: Top Twenty Subcategories (within SITC 6 through 8) for Change in Share due to
Value Change25

Change in Share due to Value Change,

SITC 6 through 8, 3-digit level category 2002-4
752 Automatic data processing machines, n.e.s. 11%
764 Telecommunication equipment, n.e.s.; &
parts, n.e.s. 8%
759 Parts, accessories for machines of groups
751, 752 5%
845 Articles of apparel, of textile fabrics, n.e.s. 3%
894 Baby carriages, toys, games & sporting goods 3%
776 Cathode valves & tubes; diodes; integrated
circuits 3%
763 Sound recorders or reproducers; television
record. 3%
851 Footwear 3%
778 Electrical machinery & apparatus, n.e.s. 3%
842 Women's clothing, of textile fabrics 2%
821 Furniture & parts; bedding & similar stuffed
furni. 2%
841 Men's clothing of textile fabrics, not knitted 2%
893 Articles, n.e.s., of plastics 2%
772 Apparatus for electrical circuits; board,
panels 2%
658 Made-up articles, of textile materials, n.e.s. 1%
699 Manufactures of base metal, n.e.s. 1%
848 Articles of apparel, clothing access.,
excluding textile 1%
653 Fabrics, woven, of man-made fabrics 1%
871 Optical instruments & apparatus, n.e.s. 1%
771 Electric power machinery, and parts thereof 1%

Source: OECD Data and authors’ calculations

25To calculate this, we look at the change in the unit value, relative to the average, from 2002-4
relative to the original percentage of total value in 2002. This gave us a percentage that
presents the unit-value change component of the shift in share toward the sector.

24
 The Beijing Bubble: Inequality, Trade and Capital Inflow into China

James K. Galbraith
Professor
Lyndon B. Johnson School of Public Affairs
The University of Texas at Austin
Austin, Texas

Sara Hsu
Adjunct Professor of Economics
St. Edwards University
Austin, Texas

Wenjie Zhang
LBJ School of Public Affaits
The University of Texas at Austin
Austin, Texas

May 31, 2008

The University of Texas Inequality Project

UTIP Working Paper 50

Abstract

This paper explores the relationships between inequality, trade and capital flows into China since
the early 1990s. We show that the rise in inequality in China since 2000 has more to do with the
speculative activities associated with China’s building boom, notably in Beijing, than with the
massive growth in manufacturing employment and in Chinese exports since China joined the
WTO in 2001. The paper also reports further research on the likelihood of large speculative
inflows of capital into China via the current account. An earlier argument for this phenomenon
based on inspection of apparent export unit values by sector did not withstand scrutiny in more
detailed data sets. Rather, it is the flow of profits from the export boom that has, most likely, fed
the speculative fires in the capital and elsewhere.

1
This paper explores the relationships between inequality, trade and capital flows into China since

the early 1990s and particularly in the first years of the present decade. We show that the rise in

inequality has more to do with the speculative activities associated with China’s building boom,

notably in Beijing, than with the massive growth in manufacturing employment and in Chinese

exports since China joined the WTO in 2001. Nevertheless, it is the flow of profits from the

export boom that has, most likely, fed the speculative fires in the capital and elsewhere.

By all accounts, inequality rose rapidly in China beginning in the early 1990s (Riskin et al.,

2001). Measurements by Galbraith, Krytynskaia and Wang (2004) showed that much of the rise

in that decade could be attributed to the relative gains of just one province and two municipalities:

Guangdong, Shanghai and Beijing, and to the relative earnings gains of just three sectors:

transportation, utilities and banking. Major regional losers in relative terms included the

Northeast (Manchuria) and the Southwest (Sichuan); across sectors the major losers included

manufacturing, farming and trade.i

Figure One presents a broad overview of the evolution of pay inequality in China, overall and by

region and sector, through 2005. The method consists of calculating the contribution of each

sector within each province to the between-groups component of a Theil T statistic for the whole

country, and then aggregating the components by sectors and by provinces to achieve measures

of inequality between and within provinces. The figure shows that while during the 1990s

inequality between provinces and inequality within provinces (that is, between sectors) both rose,

in the 2000s the behavior of these two dimensions of inequality has diverged. Inequality

2
between provinces peaked early in the decade, and has actually declined since 2001. In contrast,

inequality within provinces continued to rise.

Figure 1. Inequality between and within provinces in China, 1987-2006.

The Overall Theil Inequality Index for China from 1987 to 2006
Between-Groups Component of

0.09
0.08
0.07
Theil's T Statistics

0.06
0.05
0.04
0.03
0.02
0.01
0
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
Year

Overall Inequality Between Provinces Within Provinces

Source: China Statistical Yearbook and authors’ calculations

Figure Two breaks out the changing inter-regional dimensions of Chinese inequality in a stacked

bar graph. Each bar represents a year and each segment represents the “contribution” of a

province to overall inequality in that year. Each segment reflects both the population weight of

the province (measured by observed employment) and the ratio between average provincial

income and national average income. Contributions greater than zero indicate provinces with

mean incomes above the national average. Contributions below zero indicate provinces with

incomes below average. Overall inter-provincial inequality is measured by the sum of all the

elements in a given year; however the statistic is so constructed that longer bars represent higher

inequality and vice versa.

3
Figure 2. Contribution of provinces to inter-provincial inequality in China, 1987-2006.

0.20000

0.15000

0.10000
Theil Elements between Provinces

0.05000

0.00000

-0.05000

-0.10000

-0.15000
1989 1988 1987 1991 1990 1992 1993 1994 1996 1995 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Year

Beijing Shanghai Guangdong Zhejiang Jiangsu Tianjin Tibet Qinghai Ningxia

Hainan Chongqing Inner Mongolia Xinjiang Liaoning Yunnan Gansu Guizhou Fujian
Guangxi Anhui Shanxi Jilin Shaanxi Hunan Jiangxi Sichuan Shandong
Heilongjiang Hebei Hubei Henan

Source: China Statistical Yearbook and authors’ calculations

The figure shows that the enormous relative contribution of Guangdong province to overall

inequality in China actually peaked as far back as 1994, while that of Shanghai reached its zenith

around 2000 or 2001. Despite their respective positions as the seat of Chinese export trade and

the financial center, both were regressing moderately toward mean income by 2005 -- as incomes

elsewhere rose. Uniquely among the big three, the relative contribution of Beijing continued to

rise, reflecting in part, no doubt, the acceleration of a program of urban reconstruction and a

speculative building boom in advance of the 2008 Olympics. The recent rise of a fourth

contender – Zhejiang province – rounds out the contrasting picture of convergence and

4
divergence as the great Chinese coastal development boom matures. able One presents some

evidence on trends in manufacturing employment across China during the early years of the new

millennium. The table shows that in most Chinese provinces manufacturing employment

declined from 2002 through 2006. But there are great exceptions: Guangdong, Zhejiang, Fujian,

Jiangsu and Shandong, where manufacturing employment rose by a cumulative total of 4.9

million jobs during these four years. All are deeply involved in China’integration into world

markets following accession to the WTO. Their expansion offset a net decline in manufacturing

employment of 1.5 million jobs spread across the rest of the country, giving China as a whole a

net gain in manufacturing employment exceeding ten percent in that period. Or, in four years

these five Chinese provinces added manufacturing jobs equal to thirty-six percent of the

remaining manufacturing employment in the United States as of April, 2008.

Table 1. The total number of manufacturing workers by provinces (10000 persons)

Source: State Statistical Yearbook

The total number of manufacturing workers in the major export provinces (10000 persons)
Year/Region Jiangsu Fujian Shandong Guangdong Zhejiang Rest of country
2002 216 134 272 255 97 1933
2003 217 152 270 282 109 1869
2004 223 181 280 315 152 1810
2005 245 198 334 357 201 1762
2006 281 215 342 387 240 1786

It is obvious that these gains in manufacturing employment are closely tied to exports. After

rising at just over 10 percent per year, on average, from 1999 through 2001 (two years of boom

and one of recession in the US), China’s exports started to surge in 2002. They rose 21 percent

that year, and then 35 percent in each of the two following years, before settling back to a

reported rate of 28 percent in 2005 and 27 percent in 2006. Overall the reported increase in

5
exports in dollar terms from 2002 to 2006 amounts to a staggering 264 percent. There is no

question that a large part of this is “real,” in the sense that reported quantities surged, alongside

manufacturing employment in the key exporting provinces.

It is interesting that, apart from the rise of Zhejiang, the post-2001 export boom in China had

little effect on inequality as measured between provinces. The explanation is however not far to

seek. Though manufacturing in China is a low-wage sector, in high-wage provinces pay in

manufacturing can be close to, or even slightly above, national average pay rates. Thus an

increase in the manufacturing share of employment would not necessarily increase overall

inequality in China: the contribution of a sector whose average pay is close to the national

average to overall inequality is necessarily small. This is sufficient to explain why strong growth

in export-oriented manufacturing employment need not have had a dramatic impact – one way or

the other -- on the inequalities of Chinese society. In contrast, the much higher incomes in

banking, utilities, government and real estate in Beijing have a powerful effect on inequality;

there is little else in the country quite like them.

Table Two presents the Chinese current account, as officially reported. It may be considered in

light of one of the most basic principles of international macroeconomics, that the growth of

imports depends on the domestic growth rate, while that of exports depends on growth in

external markets. Thus when a developing country experiences a prolonged period of high

internal growth, it is normal for a trade deficit to emerge. This is especially likely if the country

in question is an importer of food and fuel, and if commodity prices are rising. Innumerable

cases can be cited; exceptions, per contra, are rare, and in the modern record largely confined to

6
countries that maintain rigorously undervalued exchange rates and repressed domestic

consumption, while rapidly improving the composition and quality of their exports.

Table 2. China’s Balance of Trade, 1998-2006.

(Billions of USD)

Exports of Imports of Balance of

Goods Goods Trade
1998 184 140 44
1999 195 166 29
2000 250 225 25
2001 266 244 22
2002 323 295 28
2003 438 413 25
2004 593 561 32
2005 762 660 102
2006 969 791 178
Source: China Customs

Seen from this perspective, Table Two is astounding. China has been running reported internal

real growth rates of eight percent or so for three decades, during which time OECD growth rates

averaged less than half of that figure (WDI Online). And while during most of this period China

reported small trade surpluses, in the most recent years China’s exports have exploded. China’s

imports also rose sharply during this period, but exports measured in dollars grew even more,

nearly quadrupling from 2000 to 2006: a rise of nearly three-quarters of a trillion dollars. Thus

China reported a trade surplus of $103 billion in 2006 in goods and services taken together; the

figure for goods alone was $178 billion. Given a dollar value of Chinese GDP at the prevailing

exchange rate on the order of three trillion dollars in 2006, exports amounted to nearly a third of

GDP by that time and trade openness (exports plus imports) to over half.ii

7
We have examined a number of explanations for this extraordinary turn of events. First, we

find no trace of any transformation in unit prices of Chinese exports. Information on the unit

prices of imports from China are maintained by European authorities, while the U.S. reports

price indices of imports in general. Nothing of consequence seems to have happened in either

dataset; indeed dollar prices of Chinese manufactures imported into Europe fell (not surprisingly,

given the rise of the euro against the dollar).

Although data we analyzed in a previous working paper (Galbraith, Hsu and Li, 2007) suggested

that there was a large (and suspicious) increase in reported unit values of Chinese exports after

2002, further research has deflated this conclusion. Our original hypothesis was that quantity

units reported by major product category in OECD summary data could be assumed to be

reasonably consistent over short time periods, permitting us to use aggregated, heterogeneous

quantities as a rough index of actual shipments. Inspection of the underlying data tables from

Comtrade reveals that large changes in reported units did occur (in some instances shifting from

actual units to thousands of the same units); thus in most (though not all) categories the

hypothesis of extraordinary changes in unit value cannot be sustained.

There have been modest shifts in the composition of exports toward higher-valued goods,

notably an increase of about three percentage points per year in the export share of the machinery

and transport equipment sector. But this increase had been going on for a long time, and the

gains after 2002 are not out of line with past experience. So while China is always in the process

of upgrading its manufactured exports, the major push behind the post 2001 boom has been

8
expansion in reported shipments (quantities) rather than in the value-added associated with

particular units (price or quality change).

A fourth possibility appears to have better traction: the decline of the dollar. China exports to

both Europe and the US, and while the relative stability of the dollar/RMB exchange rate assures

that the dollar value of Chinese exports to the US does not fluctuate with the dollar itself, this is

not true for Chinese exports elsewhere. Notably, if prices in the final markets do not change, then

the euro’s rise would automatically generate larger per-unit dollar earnings for China. But the

same effect would work on imports from outside the dollar zone, so it is difficult to see how this

artifact of the reference currency would strongly affect the rise in China’s trade surplus.v

A fifth possibility concerns the processing trade, a large share of China’s manufactured exports.

China could be importing increasingly high-value goods (from, say, Japan) in order to finish

them and export them again. But if this were the case, then reported unit values of Chinese

imports in manufacturing would also be increasing, and so would the share of the processing

trade in total trade. Neither of these things appears to have occurred. Although there is a slight

progression in import prices in manufacturing from 2001 onward, no dramatic increase is

observed. Moreover, processing trade accounts for about 55 percent of Chinese exports, and that

figure remained stable after 2001.vi If the rise in total export values were due mainly to rising

unit value of processed goods, the share of the processing trade in total exports should have risen.

From the remarkable boom in manufacturing employment, coupled to the increase in unit sales,

it appears plain that after 2001 China’s exporters took full advantage of their position as a WTO-

9
compliant country, and greatly multiplied their efforts and their results. This calls to mind a

comment in Galbraith (2006), following a discussion of the difficulties of making a profit on the

manufacture of wage goods for the home market, given the hyper-competitive climate for light

industry in China:

“Is there any way for the Chinese manufacturing firm to turn a profit? Yes: the

obvious alternative to selling on the domestic market is to export. And export

prices, even those paid at wholesale must be many times those obtained at home.”

It would not be surprising, therefore, if an export boom should lead to a profits boom, followed

by the speculative concentration of profit incomes in, for example, Beijing real estate. This

would appear to be the fundamental mechanism of rising inequality in China in the post-WTO

environment.

But if something can be done, it can also be overdone. Since China still maintains capital

controls, perhaps Chinese exporters have been over-reporting exports to the Chinese authorities,

for the purpose of bringing foreign capital into the country? Perhaps they have been over-

invoicing the exports they actually made? Or perhaps they have been, even more simply,

reporting exports to the authorities that were never made at all? The next section of this paper

considers this possibility, which has been discussed at least to some extent by Chinese officials.

There are straightforward reasons why it would be in the interest of Chinese firms to behave this

way, if they could get away with it. The incentive stems from China’s property and stock market

10
booms, and from two regulatory facts: the continued enforcement of controls over capital inflows

per se in China, and the legalization, in late 2002, of unlimited foreign currency accounts held in

China by Chinese firms. The simple solution from the firm’s point of view in this situation

would be regulatory arbitrage: to launder the capital inflow through the current account.

At this point, we are unable to present estimates of the extent to which disguised capital inflow

may be occurring; as noted the preliminary estimates in earlier work already cited did not

withstand further scrutiny. Detailed forensic work, case studies of the relevant sectors, shipping

data, measures of unit imports from the advanced countries, and insider accounts would now

appear to be necessary to establish whether regulatory arbitrage is really a large issue. We

therefore restrict ourselves, for now, to examining the enabling conditions.

Changes in the Financial Environment

In 2003, there were several changes in China’s financial sector which made the environment

more favorable to capital inflows. The interest rate began to look more attractive vis-à-vis the

dollar, while the NDF premium began to decrease, indicating expectations of RMB appreciation

against the dollar (Ma and McCauley (2007, p. 16). Table Three illustrates the interest rate

trends.

11
 Table 3: RMB Less Dollar Yields

(Percent)

Average 3-month Average 3-month

Chinese Repo less US CHIBOR less USD
Treasury Yield LIBOR
1998 1.96 2.23
1999 -1.17 0.95
2000 -3.4 -2.46
2001 -0.83 0.03
2002 0.54 1.6
2003 1.59 1.66
2004 1.35 1.71
2005 -1.44 -0.77
2006 -2.41 -2.57
Source: CEIC, US Treasury Statistics, British Bankers Association

Further, in October 2002, the central government gave permission for all companies to hold

foreign exchange accounts. Controls over foreign exchange purchases were relaxed for many

businesses, including exporters, while the ability to open foreign exchange accounts was

extended to firms outside bonded zones (Lehmanbrown.com, 2002). The goal of this measure

was to liberalize the current account, facilitating trade and reducing the state presence in credit

markets. Not surprisingly, Table Four shows that foreign exchange transactions within China

increased tremendously beginning in 2003.

12
 Table 4: Foreign Exchange Transactions within China

(100 Million Units)

Overall USD HKD JPY EURO

Turnover Trading Trading Trading Trading
(in USD) Volume Volume Volume Volume
2001 750.3 741.3 30.6 613.9 N/A
2002 971.9 951.1 108.8 730.8 1.1
2003 1511.3 1478.2 186.3 761.6 3.0
2004 2090.4 2044.1 244.9 1349.6 1.9
Source: People’s Bank of China

Thus, the regulatory and investment environment was ripe for injecting capital inflows into

China. Exporting companies with a willing partner simply had to overstate or over-bill exports,

and foreign exchange could be transferred into their bank accounts, from which it could be

converted into RMB and used in domestic capital markets.

Did they do so? The recent crackdown on short-term foreign exchange accounts, and the

punishment of both foreign and domestic banks for the violation of exchanging currency outside

of controls, has revealed how loose controls over foreign exchange accounts had become.

Further evidence comes from the recent exposure and punishment of a large underground bank

headquartered in Shenzhen, which exchanged foreign currency and maintained foreign exchange

accounts. All of these measures are attempts by the central government to curb hot money

inflows and illegal foreign exchange transactions, in order to maintain better control over the

current accountviii.

Part of the flow, too, may stem from over-billing exports to receive additional Value-Added Tax
ix
(VAT) rebates after the January 2002 legislation loosened restrictions over VAT rebates.

13
However, in our calculation, we do not see a large unit price increase for the year 2002, which

would indicate that VAT abuses due to the legislation have not been very large.

Profit and Capital Inflows Into Speculative Sectors

We now examine the extent to which these funds – both licit and otherwise -- may have

contributed to China’s building boom and particularly to the “Beijing Bubble.” A clue to the

phenomenon at hand may possibly be found in the percentage change in gross capital formation.

This figure increases sharply in the post 2002 years, while the share of capital formation in GDP

rises by seven percentage points between 2001 and 2004. This is the result of an enormous

increase in the construction of fixed assets such as plant and equipment, offices and housing.

The increase in gross capital formation reflects the construction boom that is everywhere visible

in urban China. Table Five gives the basic information.

14
Table 5: Gross Capital Formation

GDP (billions of Gross capital Percentage Share of

current US$) formation change in Gross
(billions of gross Capital
current US$) capital Formation in
formation GDP
(%) (%)
1996 856.1 346.2 40
1997 952.7 361.5 4 38
1998 1,019.50 378.2 5 37
1999 1,083.30 398 5 37
2000 1,198.50 420.9 6 35
2001 1,324.80 480.5 14 36
2002 1,453.80 550.5 15 38
2003 1,641.00 676.1 23 41
2004 1,931.70 835.7 24 43
2005 2,243.90 971 16 43
2006 2,668.10 1,085.80 12 41

(Current US Dollars or Percent where indicated. Source: WDI and authors’ calculations)

An inflow of export profits, an increase in the profit share in total income, and any foreign

capital would need to show up as reported profits in Chinese industry – not only directly but in

the sectors ultimately targeted by investment and speculation. This too we observe. To take a

specific instance, the Beijing real estate industry operating income and profit moves sharply from

negative to positive numbers in 2003, a dramatic increase. Table Six gives the data.

15
 Table 6: Beijing Real Estate Statistics

(Million Yuan)

Real Estate Industry Real Estate Industry Investment in Commercial

Operating Income Total Profits Office Buildings Buildings Sold
2000 -1862 -1303 4521.9 424.84
2001 -1046 -215.3 7199.3 1245.8
2002 -1026 -587.1 9732.6 2595.3
2003 895.9 1743.3 14275 5177.9
2004 8661.1 10701 18789 5883.4
2005 6184.4 8131 19617 12085
2006 11053 14959 21674 16256
Source: CEIC

Caveats and Qualifications

We note several further qualifications, arising from Chinese economic statistics as noted in other

literature. First of all, there are problems with Chinese GDP, particularly with the overstatement

of GDP for political purposes, and with the notorious stability of reported Chinese GDP growth

rates. There are well-known problems with the trade statistics, due to the treatment of re-exports

from Hong Kongx. There are also problems with achieving continuous measures of trade activity

over recent years, due to shifts in statistical classifications, e.g. as several export categories were

broken into sub-categories, while some were discontinued. However, this did not affect trade

statistics within the larger SITC categories.

Conclusion

While the rise in Chinese inequality seems to have slowed in the middle of the first decade of the

twenty-first century, a significant force for continued increases remained, associated with the
16
property boom and other speculative activities that concentrated on the national capital, Beijing,

during the period immediately before the 2008 Olympics. The most likely mechanism behind

the flow of funds into these sectors is a profits boom associated with the extraordinary increase

in Chinese exports that followed WTO accession in 2001. There is reason to suspect that some

additional speculative flows occurred by the device of laundering capital inflow through the

current account, but despite concentrated efforts we have no firm estimates to offer.

17
Appendix

Tables Seven, Eight and Nine present the sectors with the largest proportionate increases in

quantities and values exported. Interestingly, the largest quantity increases are in the metals

sectors—rolled steel, pipe, aluminum -- followed by certain electronics sectors. We have no way

of judging, a priori, whether an eleven-fold increase in flat-rolled steel exports in four years is

plausible or not; we only note that in this and other important sectors the numbers appear to be

remarkably high.

These sub-sectors show increases that are very large for such a short time frame, though they are not

beyond the bounds of possibility.

18
 Table 7: Top 15 Categories (SITC 6 through 8) of Changes in Quantities Exported, 2002-6

SITC SITC Description Change in Dollar change in value

Category Quantity, 2002-6 2002-6 (in millions)
673 Flat-rolled products of iron or non-alloy steel, 1126% 7220.2
not clad, plated or coated
7643 Transmission apparatus for radio-telephony, 653% 29707.5
radio-telegraphy, etc
679 Tubes, pipes and hollow profiles, and tube or 521% 6213.7
pipe fittings of iron or steel
7722 Printed circuits 461% 5847
7764 Electronic integrated circuits and micro- 414% 17148.6
assemblies
7843 Other parts and accessories of the motor 380% 7008.8
vehicles of 722 and 781-3
77812 Electric accumulators (storage batteries) 340% 3677.2
77121 Static converters (e.g., rectifiers) 272% -14721.9
6531 Fabrics, woven, of synthetic filament yarn 268% 7937.6
(not pile and chenille fabrics)
684 Aluminum 251% 5144.9
8943 Video games of a kind used with a television 242% 2795.9
receiver
747 Taps, cocks, valves, etc; pressure-reducing, 229% 4186.5
thermostatically control valves
7725 Electrical apparatus for switching, protecting 227% 3543.7
electrical circuits, for ≤ 1000 V
7649 Parts or accessories suitable for use solely or 217% 22511.2
principally with apparatus of 76
763 Sound recorders or reproducers; television 215% 14825.7
image and sound recorders
Source: UN Comtrade

19
Table 8: Top 15 Categories (SITC 6 through 8) of Changes in Unit Values of Exported Goods,
2002-6

SITC SITC Description Change in Unit Dollar change in value

Category Value, 2002-6 2002-6 (in millions)

87193 Other optical devices, appliances and 1201% 12379.2

instruments
793 Ships, boats (including hovercraft) and 841% 6185.2
floating structures
761 Television receivers 493% 10563.2
751 Office machines 270% 4637.1
752 Automatic data processing machines and 220% 72885.1
units thereof
7641 Electrical apparatus for line telephony or line 195% 6701.3
telegraphy
6531 Fabrics, woven, of synthetic filament yarn 188% 7937.6
(not pile and chenille fabrics)
673 Flat-rolled products of iron or non-alloy steel, 186% 7220.2
not clad, plated or coated
671 Pig-iron, spiegeIeisen, sponge iron, iron or 179% 2026.1
steel granules and powders
684 Aluminium 171% 5144.9
773 Equipment for distributing electricity, nes 168% 5378.3
747 Taps, cocks, valves, etc; pressure-reducing, 163% 4186.5
thermostatically control valves

7649 Parts or accessories suitable for use solely or 162% 22511.2

principally with apparatus of 76

844 Women's or girls' outerwear, of textile 161% 7399

fabrics, knitted or crocheted

759 Parts and accessories (not covers, carrying 157’\% 20756.9

cases, etc) for machines of 751-52

Source: UN Comtrade

20
Table 9: Top 15 Categories (SITC 6 through 8) of Changes in Volume-Weighted Unit Values of
Exported Goods, 2002-6

SITC SITC Description Change Dollar

Category in change in
Volume- value
weighted 2002-6
Unit (in
Value, millions)
2002-6
87193 Other optical devices, appliances and instruments 6265% 12379.2

673 Flat-rolled products of iron or non-alloy steel, not clad, plated 1304% 7220.2
or coated
793 Ships, boats (including hovercraft) and floating structures 1190% 6185.2

761 Television receivers 897% 10563.2

679 Tubes, pipes and hollow profiles, and tube or pipe fittings of 351% 6213.7
iron or steel

752 Automatic data processing machines and units thereof 341% 72885.1

6531 Fabrics, woven, of synthetic filament yarn (not pile and 319% 7937.6
chenille fabrics)
751 Office machines 285% 4637.1
684 Aluminium 248% 5144.9
7764 Electronic integrated circuits and micro-assemblies 213% 17148.6

7641 Electrical apparatus for line telephony or line telegraphy 208% 6701.3

Pig-iron, spiegeIeisen, sponge iron, iron or steel granules and

671 powders 206% 2026.1
Taps, cocks, valves, etc; pressure-reducing, thermostatically
747 control valves 205% 4186.5

Other parts and accessories of the motor vehicles of 722 and

7843 781-3 204% 7008.8

Equipment for distributing electricity, nes

773 191% 5378.3

Source: UN Comtrade

21
References:

James K. Galbraith, “The Firm, Exports, the Banks and the Real Wage in China,” A Note,
Prepared for the meeting on Institutional Reform in China, Manchester, UK, August 8-9, 2006.

James K. Galbraith, Sara Hsu and Jianjun Li, “Is China Really Running a Trade Surplus?”, UTIP
Working Paper No. 45, December 30, 2007.

James K. Galbraith, Ludmila Krytynskaia and Qifei Wang, "The Experience of Rising Inequality in
Russia and China during the Transition." European Journal of Comparative Economics, Vol 1, No. 1,
2004.

Carl Riskin, Zhao Renwei, Li Shi, editors. China's retreat from equality : income distribution
and economic transition, Armonk, N.Y. : M.E. Sharpe, c2001.

Lehmanbrown.com, http://www.lehmanbrown.com/FAQ/FAQ-Forex/2.htm (2002)

Ma, Guonan and Robert N. McCauley. “Do China’s Capital Controls Still Bind? Implications
for Monetary Autonomy and Capital Liberalization,” BIS Working Paper No. 233, www.bis.org.

Naughton, Barry. The Chinese Economy, MIT Press: Cambridge, MA 2007.

World Bank. World Development Indicators (WDI) Online.

About the Authors:

James K. Galbraith, LBJ School of Public Affairs, The University of Texas at Austin. Sara Hsu,
Trinity University, San Antonio, Texas. Wenjie Zhang, LBJ School of Public Affairs, The
University of Texas at Austin.

i
These results are drawn from data on pay and employment in the State Statistical Yearbook. They are consistent
with, but considerably more revealing than, surveys which have tended to characterize the growing gap in Chinese
incomes as “urban/rural” or “coast/interior.”
ii
The IMF’s world economic outlook pegs nominal GDP for China in 2006 at $2 trillion, in comparison to which
the official trade statistics look even larger. http://www.econstats.com/weo/index_glweo.htm. We have not tried to
unravel the discrepancy, except to say that all such comparisons are clearly open to skeptical appraisal.
v
Were the reference currency switched to the euro, the rise in China’s export earnings would appear lower, since
the country’s exports to the U.S., measured in euro, would have been sharply cut by the dollar devaluation. Similar
effects would apply on the import side: China’s eurozone imports would not have risen so much, while its dollar-
zone imports would have risen considerably more.
vi
http://www.mofcom.gov.cn/tongjiziliao/tongjiziliao.html

22
viii
In addition, the real appreciation of the RMB in terms of the dollar in December 2006 signals a change in the
desirability of purchasing RMB with dollars.
ix
VAT rates range from 5-17%. The standard VAT rate is 17%.
x
Green writes that the US exaggerates value-added in Hong Kong as around 25% of China’s goods value, while
China tends to understate these values. He believes the US-China deficit may be the average of the two records. In
any case, China’s understatement of Hong Kong re-exports has not changed over time, so does not affect the general
unit value trend.

23