Life has few certainties except for death, taxes, and large Chinese trade surpluses. The expected large Chinese trade surpluses are always referred to as both proof of the strength of the Chinese economy and its financial foundation as money continues to flow in. In nominal RMB terms, the trade surplus amounted to 5.5% of GDP or 79% of total GDP growth. In other words, in 2015 China is almost entirely dependent on maintaining a large trade balance to drive GDP growth.

However, what if the assumed trade balance did not actually exist? In fact, how would it change our understanding of the Chinese economy and financial markets if the assumed trade surplus was actually a trade deficit? Unfortunately, this is not a counterfactual but the reality. China is running a small trade deficit.

The widely cited international trade data is provided by Chinese customs records. The value of goods leaving and entering and China is recorded by the Customs Bureau. According to Customs data, China imported $1.69 trillion (10.45 trillion RMB) and exported $2.27 trillion (14.14 trillion RMB) for a resulting trade balance of $593 billion (3.7 trillion RMB). These often repeated numbers form the basis for why China is running a large trade surplus.

Before explaining why China has no trade surplus, it is important lay some related groundwork. By now China watchers knows about the practice of trade misinvoicing. This is the practice where, as originally executed, capital was either moved into or out of the country based upon fraudulently invoicing an import or export. For instance, by over invoicing an export, capital can flow into China as the foreign counter party is over paying for the good and vice versa for imports.

To take one example, of trade between Mainland China and Hong Kong, there are significant discrepancies between the value reported to Chinese customs and Hong Kong customs. Hong Kong reported imports from China worth $255 million USD but China reported exports to Hong Kong of $335 million USD. The 31% difference in customs prices, or $79 million, is too large to be unintentional and acts as a capital inflow into China. Conversely, China reports $12.8 billion USD of imports from Hong Kong but Hong Kong only reports $2.6 billion USD of exports to China. The 385% difference is far in excess of the low mid to single digit invoicing discrepancies that are standard in global trade. Consequently, the $10.1 billion USD in over invoiced Chinese “imports” acts as a capital outflow from China.

Misinvoicing contributes a not entirely insignificant share to unrecorded capital inflows and outflows. However, Chinese authorities have become much more aware and concerned about these issues and gone through various waves of cracking down over this issue. Furthermore, the aggregate sums here are not enough to move the RMB and cause the currency pressures we are currently seeing. In fact, misinvoicing is merely the beginning of the financial flow problems in trade with Chinese innovation taking it a step further.

China, as a country with strict currency controls, maintains records on international financial transactions sorted by a variety of categories. For instance, there is data on payment or receipt of funds by current or capital account, goods or service trade, and direct or portfolio investment. For our purposes, this allows us to compare in a relatively straightforward manner, how international payments are flowing compared to the customs reported flow of goods.

The differences in key data surrounding trade data is illustrative. Chinese Customs data reports goods exports valued at $2.27 trillion, with SAFE reporting goods exports of $2.14 trillion but Chinese banks report receipts of $2.37 trillion. In other words, funds received for exports of goods and services or about $100 billion higher than reported. At 4-11% higher than the Customs and SAFE reported values this is slightly elevated, but given expected discrepancies in the mid-single digits, this number is slightly elevated but not extreme.

The differences between import and international payment data, however, is astounding. Whereas Chinese Customs reports $1.68 trillion and SAFE report $1.57 in goods imports into China, banks report paying $2.55 trillion for imports. In other words, funds paid for imported goods and services was $870-980 billion or 52-62% higher than official Customs and SAFE trade data. This level of discrepancy is extreme in both absolute and relative terms and cannot simply be called a rounding error but is nothing less than systemic fraud.

If we adjust the official trade in goods and services balance to reflect cash flows rather than official headline trade data as reported by both Customs and SAFE, the differences are even worse. According to official Customs and SAFE data, China ran a goods trade surplus of $593 or $576 billion but according to bank payment and receipt data, China ran a goods trade surplus of only $128 billion. If we include service trade, the picture worsens considerably. China via SAFE trade data reports a $207 billion trade deficit in services trade. Payment data reported via SAFE actually reports about $42 billion smaller deficit of $165 billion. In other words, the supposed trade surplus of $600 billion has become a trade in goods and services deficit of $36 billion. Expand to the current, through a significant primary income deficit, and the total current account deficit is now $124 billion.

There are two very important things to emphasize about these discrepancies. First, the imports customs and payment discrepancy is responsible for essentially all of the discrepancy between payments and customs. Neither goods exports or differences between service imports at customs and payments explain the difference. In fact, service is underpaid according to payment and customs data. Second, if there was a more benign explanation, we would expect to see symmetry between various categories. Rather, we see most categories reconciling close enough and one channel, conveniently enough one that funnels capital out of China, enormously mis-stated.

This discrepancy between official reported trade data and bank payments is a relatively new phenomenon but has been growing rapidly and reveals important details about flows into and out of China. For instance, since 2010 China has an aggregate trade in goods and services surplus based upon payments of 1.9 trillion RMB; however, since 2012 an aggregate deficit of 120 billion RMB. 2010 and 2011 were the only years where China ran a trade in goods and services surplus using payments data rather than customs data. Expanding to consider the current account significantly worsens the outlook. From 2010 to 2015, China has run a current account surplus of 462 billion RMB but from 2012 to 2015 ran a deficit of 1.44 trillion RMB. The reason for the shift is simple. In 2012, China freed international currency transactions made through the current account creating an enormous asymmetry.

There are a number of important conclusions and implications of the data presented here. First, if we adjust the Chinese traded good surplus on a cash flow basis and include the trade deficit resulting in a net export deficit, Chinese GDP growth in 2015 grew only 0.3%. If a positive trade balance in economic accounting directly adds to GDP growth then a deficit directly reduces it. Consequently, swinging from a goods trade surplus of 5.5% of GDP to a goods and services trade deficit of negative 0.3% of GDP has an enormous impact on GDP growth rates. There is a key distinction here that is important to note and that is on a cash flow basis. Economic accounting holds that GDP grows because when running a trade surplus, additional cash flow is received than is expended. This leads to higher investment through savings. In 2015, financial flows indicate this did not happen and there was not trade surplus on a cash flow basis due to the discrepancy between Customs and SAFE reported trade in goods and services values and what banks paid.

Second, the impact on real GDP and output is currently unknown. There are numerous reasons to question the veracity of numerous aspects of the data which would change our understanding of the data. For instance, there are examples of goods round tripping into and out of China designed solely to facilitate implicit capital transactions. Given the enormity of the discrepancy we see in payments for imports, we cannot rule out that a not insignificant amount of trade was either round tripping or phantom trade. As physical output of many products from industrial to consumer only increased in the low single digits, this would match closer the implied Chinese growth rate of 0.3%.

Third, this sheds new light on the state of Chinese finances and RMB outflows. For instance, the differential between Customs and bank data reveals rising outflow discrepancies since 2012. While many have begun to worry recently about rising pressure on the RMB, it is clear that outflows from China are long lasting, large, and completely domestically driven. In 2015 the capital account maintained healthy levels with the outward direct investment balance in a small deficit of 28.3 billion RMB while the securities investment balance was in an even tinier deficit of 2.9 billion RMB. Consequently, calls for “temporary capital controls” or attributing it to a recent increase in outward direct investment reveal a profound misunderstanding of what the problem is. There is nothing temporary, foreign, or speculative about RMB outflows. In fact, quite the opposite. It is domestically driven long term capital flight which should change the framework of what solutions are called for in managing RMB policy.

Fourth, the change in the current account deficit is a major driver in changes to PBOC foreign exchange reserves. While these are disguised capital outflows, for accounting purposes it is showing up in the current account statements. Consequently, while China shows only small capital account deficit of $75 billion and a cash flow current account deficit of $121 billion, this shift largely explains the currency pressures on the RMB. If you look simply at the Customs reported trade surplus, it would understandably be puzzling why the RMB is under so much pressure when China continues to run a $593 billion trade surplus. However, in reality official flows are negative to the tune of about $200 billion in 2015. Add in official net errors and omissions outflows in 2015 of $132 billion and it becomes quite clear why the Chinese RMB is under pressure.

Fifth, regardless the impact on GDP, it is quite clear that cash flows within the Chinese economy are very tight. The boost from surplus payments that is typically seen from a trade surplus is not present and firms are struggling to pay bills. Payables and receivables continue to rise rapidly as liquidity deteriorates. Again we cannot say for sure whether this is actual production being purchased or simply phantom production, though it is likely some blend of the two. What is important to note is that liquidity is much tighter within the Chinese economy than understood.

Sixth, the nature of capital flight from China cuts directly to the heart of why capital controls would be a poor remedy. Capital is not leaving through the capital account. Rather with a restricted capital account and a relatively free international transaction via the current account, enterprising Chinese are moving capital via the current account. To arrest the flood of capital leaving this way, it would require China to bring goods and services trade in the world’s second largest economy to a complete standstill. Every transaction would have to be verified for units, market price, agreement between importer and exporter, and accurate payment matching the invoice. It is simply not feasible to impose currency controls that would arrest disguised capital outflows via international goods and services payment without bring international trade in China to a halt.

It is likely the PBOC is aware of the discrepancy between Customs and SAFE reported trade data and what the banks are paying via the current account. In his interview with Caixin, PBOC Governor Zhou Xiaochuan was very careful to say that China ran a “surplus in the trade of goods” rather than current account, trade surplus, or payments and receipts for international trade. Many foreign and Chinese agencies and analysts confuse these multiple categories referring to them as one category but they are not. His mention indicates he likely understands how capital is leaving the country and why capital controls would be a poor remedy which is also indicated.

It is quite clear that the expected $600 billion trade surplus is not hitting the Chinese economy for reasons and some implications that are still unclear. What we can say, is that this is negatively impacting GDP growth and liquidity.