China: Savings Problem and the Consumption Constraint

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 more easy. 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 another 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. That means the 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 this will also 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. 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 it can decline because GDP declines, but it must decline.

That means 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 fiscal 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. If we assume that Chinese consumption continues 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. With consumption 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 this means 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”, 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 promise you that if you know beyond any doubt the direction of causality here, then you clearly 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.

About Michael Pettis 166 Articles

Affiliation: Peking University

Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business.

Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups.

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