What Increased U.S. Savings Means for China

I am, still trying to work out the implications for China of a rise in US household savings, but here is how I see it. I welcome comments that may help me refine or refute this argument.

For the sake of simplicity I am going to assume that there are only two countries, the US, which represents all the high-consuming trade deficit countries, and China, which represents all the high savings trade surplus countries. Although of course there are other players, these two represent the lion’s share of their respective blocs, and for the most part the impact of other large countries (Europe, Japan, the UK) simply exacerbate the problems as I see them.

For the past decade until the onset of the 2007-08 crisis, the US has been growing quite rapidly. Powering this growth has been an even more rapid surge in consumption. When US consumption grows faster than GDP, two things must happen.

1. The US savings rate by definition declines

2. If the country is running a trade deficit, and consumption is growing faster than production (assuming that investment isn’t falling, or is at least not falling by more than the difference), then the country must run a growing trade deficit. Another way of thinking about this is that if investment exceeds savings (and with such low savings rates, US investment needs were much higher than US savings), the country must be a net importer of capital. To be a net importer of capital the US must run a trade deficit. These are just different ways of saying the same thing.

In that case the US has been running a growing trade deficit powered by the decline in US savings. But everything must balance. If US consumption growth exceeds US growth in production (I am ignoring changes in investment because they are a relatively small part of this), then in China production must exceed consumption. This is just another way of saying that as the US savings rate declines and powers a surge in the trade deficit, the Chinese savings rate must rise and power an increase in the trade surplus. In fact this is what happened.

Notice I am saying nothing about the direction of causality. It could be US consumers who caused the change, and forced China into reacting. Or it could be China whose polices have forced an increase in the domestic savings rate (actually an increase in production greater than the increase in consumption, which amounts to the same thing), thus forcing the US financial, system to accommodate by making consumer financing easier. Or of course it could be a combination of the two. The point is that the balance of payments must and will balance. Actions in one part of the system will cause equal reactions in another part, and the direction of causality is never obvious (See Note 1).

As a consequence of the global crisis we are now seeing a sharp rise in US household savings rates. This has been partly mitigated by a sharp rise in government dis-saving (borrowing), but nonetheless aggregate US savings rates are rising, and with them US consumption must decline (See Note 2). If US GDP is also declining, the combination of a rising savings rate and a declining GDP must result in sharply declining consumption.

What does this mean for China? Obviously the US trade deficit is contracting quickly. This means that China’s trade surplus must also be contracting quickly. In fact China’s trade surplus has been growing, and this is where my simplification (the world consists of the US and China) runs into a problem. Although all trade surpluses are contracting, the fact that China’s trade surplus is rising indicates that other surplus countries are bearing more than 100% of their share of the global contraction. I don’t think this is sustainable and ultimately, perhaps even already, China’s trade surplus will decline. By the way the fact that China has been able to force at least part of its own adjustment onto trade competitors will likely lead to increasing anger with China, as it already seems to be doing especially on the part of Asian competitors, and will power a further rise in international trade tensions.

Here is the important point, I think: As long as the US was consuming more than it produced, Chinese GDP growth was constrained on the bottom by the growth in Chinese consumption. In other words, China’s GDP had to grow faster than Chinese consumption (which means of course that the Chinese savings rate was rising). In fact, while GDP was growing somewhere in the region of 11-13% annually, Chinese consumption was growing by around 9% annually. Thanks in large part to US dis-saving, in other words, Chinese GDP growth exceeded Chinese consumption growth by around 2-3% annually.

So what next? Now that the US is raising its saving rate, this means among other things that the growth in US consumption will be lower than the growth in US GDP. If the US GDP grows slowly, consumption will be flat. If it contracts, consumption will contract sharply. In either case the US trade deficit should continue declining except in the very unlikely event that US investment grows by more than the increase in savings.

Since the balance of payments must balance, if US GDP growth exceeds US consumption growth, China’s consumption growth must exceed China’s GDP growth, and Chinese savings must decline. Chinese savings can decline because consumption rises, or they can decline because GDP declines, but they must decline.

That implies that Chinese GDP growth, rather than be constrained on the bottom by consumption growth (i.e. GDP must grow faster than consumption), will now be constrained on the top by consumption growth. China’s growth in GDP, in other words, will be less than its growth in consumption unless there is a surge in investment. There has, of course, been a fiscally induced surge in investment, but with rising debt and collapsing corporate profitability, I think this can at best continue for a year or two, and probably much less.

So what does that mean for future Chinese growth? When China was growing at 11-13% a year, Chinese consumption was growing by 9% a year. The rapid reversal in the earlier decline in US savings might cause Chinese GDP growth to grow by at least 1-2% below consumption. So if we assume that Chinese consumption continues growing at 9%, this initially suggests GDP growth rates of 7-8%.

But hold on. If GDP growth rates of 11-13% translate into 9% consumption growth rates, is it reasonable to assume that GDP growth rates of 7-8% will still result in 9% growth rates in consumption? I doubt it. My guess is that the growth in Chinese consumption will also slow. This suggests that while the US is adjusting, China’s annual growth rate must be significantly below 7-8%, perhaps 5-6%, or even lower. The key is the rate of Chinese and US fiscal expansion, in the former case to permit the rise in Chinese savings rates not to constrain domestic growth, and in the latter case to slow down the contraction of the US trade deficit.

But this is just a guess, and the example of Japan after the 1987 crash and the subsequent reversal in US dis-savings suggests that while a credit bubble can keep the game going in China for a few years longer, ultimately the surprise may be on the downside. On that subject let me note something that an unnamed official confessed about the impact of the US crisis on his country’s economy:

We intended first to boost the stock and property markets. Supported by this safety net – rising markets – export-oriented industries were supposed to reshape themselves so they could adapt to a domestic-led economy. This step was supposed to bring about an enormous growth of assets over every economic sector. The wealth effect would in turn touch off personal consumption and residential investment, followed by an increase in investment in plant and equipment. In the end, loosened monetary policy would boost real economic growth.

It sounds plausible and like it might work. Except that it didn’t. The unnamed official was not an anonymous friend of mine at the PBoC. According to Tomohiko Taniguchi, in Japan’s Banks and the “Bubble economy” of the Late 1980s, the speaker was an official at the Bank of Japan and he made the comments in 1988, during a period when Japan was routinely referred to as a “creditor superpower” (and a country, by the way, with enormous foreign currency reserves, and whose currency would within one or two decades, everyone knew, become the world’s reserve currency).

After the 1987 Crash in the US, many expected the Japanese markets also to crash. But they didn’t. After faltering briefly, the Ministry of Finance ordered the Big Four brokerages to support the market, and support it they did. Within a few months the Nikkei was testing new highs, leading a Ministry of Finance official to boast that manipulating the stock market was easier than controlling foreign exchange. Check Edward Chancellor’s Devil Take the Hindmost for an illuminating take on the Japanese bubble economy of the 1980s.

The comparisons with China are, and of course are meant to be, a little worrying. This is not to say that China must repeat Japan’s spectacular 1990 crash and subsequent lost decade (or two). It is simply to point out that none of what we are seeing in China is particularly new and far from being a source of great strength, the intense manipulation of monetary and fiscal policies and the financial markets can actually make the necessary adjustment for China much more difficult. Just as Japan failed to come to terms with the sudden collapse of the US trade deficit and tried to export and monetize its way out, China may be doing something very similar.

But one way or the other if the US is raising its savings rate and so forcing more rapid growth in US GDP than in consumption, China is likely to see its consumption growth constrain its GDP growth. This suggests to me that once the effects of the (I think) unsustainable credit bubble being inflated by policymakers here run their course, we are in for a longish period of much slower GDP growth.

Note 1. I know I will be assailed on both sides by people saying that only a fool is unable to see which way causality runs in this case, but let me suggest that you that if you know beyond any doubt the direction of causality here, then you probably do not understand the problem.

Note 2. Except, of course, in the case in which US GDP is rising much more quickly than the US savings rate, which is a complication I don’t think we need to worry too much about.

Comments

[LCACM:]

Population of Japan, US and China are approximately 130Million, 300Million and 1200Million respectively. Japan has very small quantity of natural resources and land mass on a per capita basis, whereas both China and US have substantial amounts. Trying to understand what might happen in China based on what happened in Japan in the 1990's, fails to take into consideration the effects of poupulation and natural resources on financial outcomes.
Trying to make financial predictions while totally ignoring population size, land mass and available natural resources will lead to simplistic conclusions which have a higher probabilty of being wrong than right.

Jun 21 09:46 PM

[Sober Realist:]

Sources I've read say that a significant portion of the mandated lending by Chinese banks has gone into asset speculation --- as much as a third has gone into the stock market. The banks are also using low-interest mortgage-like loan structures to drive Chinese speculative inventory demand for commodities. The recent upsurge in commodities is purely speculative and a function of easy credit from banks in China. No jobs and, thus, no real growth and consumption results from expansions into such a contrived speculative economy.
"China's State Reserve Bureau has been stockpiling, but so too have producers, distributors and other speculators hoping to profit from an expected rise in prices once the world economy starts to recover....Stockpiling is fraught with risk, especially when borrowed money is used to buy goods when there is no demand, independent Shanghai-based economist Andy Xie said.
"Last year people who stockpiled went out of business," Xie said. "I know one distributor who stockpiled six million tonnes of steel and went bust when it dropped by more than half."

Many export-oriented enterprises are also cutting staff and closing factories to channel funds into the real estate market. "With loose credit, inflation expectation and the lift of measures against property speculation, more and more investors are entering the market to gamble..."
www.google.com/hostedn...
Lang Xianping believes that under the deteriorating tangible investment environment, companies cannot conduct tangible investments after receiving their funds (Chinese government stimulus money). Parts of funds, in particular those coming from the banks, enter the virtual economy, causing illusive rebound in the stock and property markets. The current rebound in the property market is not driven by the fundamental improvement of China's economy and the rise of residents’ income....It is estimated that there are vacant areas of 160 million square meters across the country. To reduce the current stock is a priority. Take Beijing for example, by the end of March, existing vacant commodity housing areas reached 14.372 million square meters, an increase of 34.5% over the same period of last year and it would at least take 13 months to digest the stock."

We know that the Western consumer will not return to any kind of spending binge. So the alternate question is this:
What will it mean for China to fail to become a Western-style, consumption-based economy?

Jun 21 11:08 PM

[王吉泰:]

How should population and / or natural resources be factored into the analysis? You might be right but I can't get my head around how it really works.

This point came to my mind as well but I wasn't very confident because I really wasn't clear on how to incorporate it. What do you think?

One related idea that has occured to me in the past has to do with a ceiling on gdp/capita when sufficient institutional quality is not in place. Many studies have shown that institutional quality moderates the growt of GDP/capita. However, there are some exceptions, such as Saudi Arabia. All of the serious execeptions (on the positive side) have vast quantities of valuable natural resources. To date, there are no execptions based on population. This may or may not be related but I share it anyway.

I look forward to hearing how to incorporate population and or natural resources into the analysis.

王吉泰


On Jun 21 09:46 PM LCACM wrote:

> Population of Japan, US and China are approximately 130Million, 300Million
> and 1200Million respectively. Japan has very small quantity of natural
> resources and land mass on a per capita basis, whereas both China
> and US have substantial amounts. Trying to understand what might
> happen in China based on what happened in Japan in the 1990's, fails
> to take into consideration the effects of poupulation and natural
> resources on financial outcomes.
> Trying to make financial predictions while totally ignoring population
> size, land mass and available natural resources will lead to simplistic
> conclusions which have a higher probabilty of being wrong than right.

Jun 21 11:41 PM

[王吉泰:]

"the direction of causality is never obvious "

Is there any research looking into methods of determining the direction of causality.

Jun 22 12:13 AM

[Phiota:]

I think China's "Buy China" directive will come back to haunt it. They should have just passed the word (to purchase Chinese made products) down the political grapevine instead of making it official.

Jun 22 12:42 AM

[Janice16:]

LCACM, I am afraid there is absolutely no empirical evidence that i have ever seen that suggests that credit bubbles vary systematically according to a country's land mass, population or access to natural resources, and given the very long history of financial crises I would be pretty surprised if any such evidence were to turn up. Similar types of financial crises have occurred in countries with both larger and smaller land masses than China and Japan, in countries with populations much smaller than either, in countries with both more dense and less dense population distributions, and in countries that are richer and poorer. They have also occurred throughout history, with the first well-recorded one taking place in 33 a.d. in ancient Rome. It is not enough to acknowledge that since two countries vary by random factor X that they cannot share possibly experiences.

Jun 22 02:51 AM

[I need more...:]

I believe as this author that China is toast.
www.philstockworld.com...

Jun 22 11:44 AM

[RayBay:]

I concur with the author's conclusion: once the effects of the (I think, ALSO) unsustainable credit bubble being inflated by policymakers here run their course, we are in for a longish (very longish) period of much slower GDP growth. Governments can't just keep trying to get consumers to over consume. Inflation could become a problem in a couple of years. Then we will have Stagflation (slow economy and inflation).
What will get us out of this mess? Game changing technological breakthroughs, maybe in the energy area.

Jun 22 02:01 PM

[Alphameister:]

I sense that the Chinese central planners understand the need for Chinese consumption to grow at a greater rate than GDP and have the tools to achieve that result, directly through outright incentives to consume and indirectly through the introduction of social safety-net programs that reduce the need for savings.

Jun 22 03:10 PM

[kappa5:]

the comparison of China with Japan in the late 1980's needs to factor in the role of Korea and Taiwan literally taking away profits from the Japanese electronics sectors. Without breaking it down into a great amount of detail, Korea and Taiwan started producing in mass and taking away a great deal of profits from Japan. I don't think this effect will occur with China. There is no nor will there be a lower cost producer to take away China's cake. So, the comparison with Japan and China does have the resonance of hubris, but I think the results will be different.

Jun 22 10:17 PM

[Simon Smelt:]

A nice piece of analysis.

Stocks as well as flows are relevant. As China's trade surpluses fall, her accumulated overseas savings will be repatriated, providing an ongoing investment boost to the economy. That investment may be so low quality that it amounts to state sponsored consumption but it can still boost the domestic economy, for a while. One of the negatives is downward pressure on the US $. To put it another way, China's accumulated savings give her some room for manoeuvre.

Jun 23 12:27 AM

[James Lewis:]

I think China (internally, externally) has more REAL money pro rata than Japan did. But I do see this as a double edged sword. Especially as the political elite are going to try and stimulate domestic demand through asset appreciation not through increasing wages etc. There are many reasons for this, the main one is that they dont want to increase wages as it will decrease their economic power externally in the current economic war. Also they can not control a huge population that have good financial resources and good life prospects. Sad, but very true. Politics and social engineering is not a nice game.

My view (and one I have held for the last year) is we are going to see a huge huge property boom created by easy lending and inventory being taken off the market by formal/informal REITs leading to buying frenzy within the population. Prices will rise by 30% in most cities. This in itself will rise domestic demand levels within the middle class. People may even start to feel safer because of the assets they hold and not want to hold so much emergency funds in deposits. This will be what increases domestic demand in the short-medium term. Things will look good for a while.

The point here is a developing emerging economy (with so much potential/spare capacity in every part of the system) can get away with doing this from an economics point of view for some time. This is after all the one of the processes of financial development. Especially when property values are cheap in relation to international norms. This suggests to me that China will be able to stabilise the price rises (by wasting its savings and a negative by-product - creating a bigger divide between rich and poor) for some time after this huge rise; BUT NOT FOREVER. And when they can no longer hold the house of cards up, the banks will be hit with such huge write-downs, the entire sector will need to be bailed out by the Chinese Government. The surplus could even turn negative. And I very much doubt many central bankers will want to buy Chinese Government debt if this happend.

Anyone that has spent anytime looking at property in Shanghai etc knows that it is funds/banks/investors/... that are holding most of the property not the people. I am amazed time-after-time when I visit sold-out blocks with no people in them. Its crazy. All the people live in the cheaper blocks wall-wall. And the more expensive blocks have hardly anyone in them. They are like ghost towns.

Rental yields are also so unbelievably low, even to those that purchased a 2-3 years ago. Everyone is holding out for the capital gain, like the stockmarket. And when I say everyone I am talking about banks/pension funds.informal/formal REIT's and some poor investors (like me). All waiting for the price rise to get out.

Just like the stockmarket, the Government is encouraging this type of behaviour which will give the market a lot of fuel in the short term.

This could even cause a significant decrease in the savings rate as money is filtered into property. Then we get the short term scenario that investment increases, consumption increases and savings fall.
Happy Days!!??

Here is the problem if the middle class net income does not rise from increase in wages/nominal wealth (can not be done through asset appreciation), there will be an abrupt end. Because there will be no buyers when everyone runs to the door.

Jun 23 01:52 PM