I mentioned in last week’s blog entry that during my trips to New York, Washington and Hangzhou in the past two weeks one of the common themes was concern about rising debt levels and weaknesses in the banking sector. Another theme – one which I want to discuss in this entry – was the possible impact of China’s rebalancing on US and global interest rates. A lot of people were very concerned that if China does indeed rebalance, US interest rates will soar.
The argument runs like this. If China raises the consumption share of GDP faster than investment declines, this will result in a reduction in China’s current account surplus. Clearly if China’s current account surplus drops, the amount of capital it exports must drop in tandem – since a rising share of consumption means a declining share of savings and so a declining excess of savings over investment which must be exported.
But because it is recycling the world’s (and history’s) largest current account surplus, China is one of the world’s largest purchasers of US government bonds. If China’s current account surplus declines, and so China sharply cuts back on its purchases of US government bonds, this should automatically cause US interest rates to rise.
In at least half the meetings I attended this was the argument. Fortunately for me, just after I returned to Beijing Martin Feldstein made the same argument in a Project Syndicate blog entry. He starts out;
China’s new five-year plan will have important implications for the global economy. Its key feature is to shift official policy from maximizing GDP growth toward raising consumption and average workers’ standard of living. Although this change is driven by Chinese domestic considerations, it could have a significant impact on global capital flows and interest rates.
He then goes on to explain that success in raising the consumption share of GDP necessarily has current account implications:
China now plans to raise the relative growth rate of real wages and to encourage increased consumer spending. There will also be more emphasis on expanding service industries and less on manufacturing. State-owned enterprises will be forced to distribute more of their profits. The rising value of the renminbi will induce Chinese manufacturers to shift their emphasis from export markets to production for markets at home. And the government will spend more on low-income housing and to expand health-care services.
All of this will mean a reduction in national saving and an increase in spending by households and the Chinese government. China now has the world’s highest saving rate, probably close to 50% of its GDP, which is important both at home and globally, because it drives the country’s current-account surplus.
…The future reduction in China’s saving will therefore mean a reduction in China’s current-account surplus – and thus in its ability to lend to the US and other countries. If the new emphasis on increased consumption shrank China’s saving rate by 5% of its GDP, it would still have the world’s highest saving rate. But a five-percentage-point fall would completely eliminate China’s current-account surplus. That may not happen, but it certainly could happen by the end of the five-year plan.
So far I more or less agree with Feldstein. I say “more or less” because of course I am much more skeptical than he is that China will be able to raise the growth rate of consumption. That doesn’t mean that China won’t rebalance, of course. It just means that it will rebalance via much slower GDP growth rather than much faster consumption growth.
The balance of payments must balance
But either way, as China rebalances, by definition the savings rate will contract as a share of GDP. In that case will the current account shrink? Probably. It is possible, of course, that investment will grow more slowly than savings, in which case the current account surplus would rise, but I suspect that this won’t happen. China is too dependent on investment, and any sharp reduction in its growth rate will translate into a collapse in GDP growth.
So I expect that China will keep investment rates higher than they otherwise should be in order to reduce the immediate impact of the slowdown. This will be more costly for China over the long run, and will mean that the slowdown extends over a period much longer than anyone now expects, but it will be a less disruptive process and easier to manage socially.
The probability, then, is that a rising share of consumption will result in a declining current account surplus. Feldstein then makes the argument that I heard repeatedly in my meetings and have often read in the press:
If it does, the impact on the global capital market would be enormous. With no current-account surplus, China would no longer be a net purchaser of US government bonds and other foreign securities. Moreover, if the Chinese government and Chinese firms want to continue investing in overseas oil resources and in foreign businesses, China will have to sell dollar bonds or other sovereign debt from its portfolio. The net result would be higher interest rates on US and other bonds around the world.
It sounds pretty straightforward, right? The PBoC is a huge buyer of US government bonds. If it is forced to stop buying because of a reduction in China’s current account surplus, this should cause yields to rise. Fewer buyers and the same amount of sellers means that prices have to drop and yields rise.
Of course this doesn’t necessarily have to happen, as Feldstein notes:
Whether interest rates do rise will also depend on how US saving and investment evolves over the same period. America’s household saving rate has risen since 2007 by about 3% of GDP. Corporate saving is also up. But the surge in the government deficit has absorbed all of that extra saving and more.
He, however thinks a cut back in Chinese recycling is likely to cause to US, and global, yields to rise. The final sentence in his piece is: “If Americans’ demand for housing picks up and businesses want to increase their investment, a clash between China’s lower saving rate and a continued high fiscal deficit in the US could drive up global interest rates significantly.”
But, but, but…
I know the idea that reduced PBoC purchases will lead to higher US interest rates is part of a very widely-held consensus, and so I am reluctant to disagree too quickly, especially when someone as smart as Martin Feldstein makes the case, but I have to say that there is something about this argument that really bothers me. I don’t think a decline in the amount of capital recycled by China, whether through the PBoC or through other institutions, will likely lead to higher US interest rates at all.
The reason I say this is because if we accept this argument, then it seems to me that we are also saying that one way for the US to reduce interest rates is to allow its current account deficit to explode to significantly higher levels. Why? Remember that foreigners don’t fund fiscal deficits. They fund current account deficits, and they do so automatically. As long as the US runs a current account deficit, in other words, it will receive exactly the same amount of net capital inflows as the size of its current account deficit. So if the US current-account deficit doubles, for example, net foreign inflows will double too.
Will that cause US interest rates to decline? Yes, if US borrowing, especially US government borrowing, stays the same. But will it? Probably not. If the US current account surplus rises because of a surge in US investment, then I would argue that the increase in the amount of savings the US imports is matched by an equivalent increase in the need for savings, and so the impact on US rates is likely to be minimal. Of course if soaring US investment (and with it soaring jobs) cause Americans to feel richer and so increase their consumption, interest rates might even rise.
What if the rise in the US current account deficit is caused not by an increase in US investment but rather by a reduction in foreign (e.g. Chinese) consumption, as might have happened in the past decade? In that case the diverting of demand from the US to China should cause a rise in US unemployment and a reduction in US growth. Washington would try to counteract the diverted demand and rising unemployment with an increase in the fiscal deficit, just as it is doing now, or the Fed might try to counteract it by keeping rates low and encouraging a surge in consumer financing, as happened before 2007. Either way US debt levels would surge.
In that case what would happen to US interest rates? If the increase in the fiscal deficit or consumer borrowing was large enough, rates are as likely to rise as to fall. And remember that rising unemployment should reduce the household savings rate, which would counteract to some extent the increased amount of global savings the US is importing through its current account deficit.
I guess this is just a long way of saying that an increase in the US current account deficit can be contractionary for the economy, and if it results in declining interest rates, we should be clear about why. It is not because the US is lucky enough to have eager foreigners lending it money. It is because a rising current account surplus can slow the economy and weak growth is likely to be associated with low interest rates.
Less foreign financing
And the reverse is true. If China’s current account surplus declines, there are, very broadly, two ways this can affect the US. On the one hand the surplus can simply be transferred to another country. For example if China’s current account surplus declines because it decides to stockpile larger amounts of commodities at higher prices, it will simply shift the need to recycle its current account surplus to a commodity exporter – say Brazil.
In that case the total US current account deficit is unchanged, and by definition the net capital the US imports is also unchanged. Brazil will do what China was doing – buy US government bonds directly or indirectly.
On the other hand a rise in Chinese consumption could cause both the Chinese current account surplus and the US current account deficit to decline. In that case of course China would buy fewer US dollar assets and so fewer US government bonds. This is more or less Martin Feldstein’s scenario.
But in that case the reduction in the US current account deficit would be expansionary for the economy in a way similar to an increase in the fiscal deficit. Both are expansionary. So the impact on the current account would probably be offset by a reduction in fiscal spending.
So yes, the PBoC, and foreigners more generally, would be buying fewer US government bonds, but the US government would also be issuing fewer government bonds, in which case it is not at all obvious whether US interest rates will rise or not. In fact I don’t think it would make any difference, except to the extent that it impacts US growth. If a consequence of a reduction in China’s current account surplus is much faster US growth, then probably interest rates would indeed rise in the US, but this doesn’t seem like a bad thing at all to me. At any rate whether or not interest rates do indeed rise would depend on Washington’s fiscal and monetary reactions to the growth.
Regular readers of my newsletter might wonder if I am not just making a variation of my old Beijing-is-not-Washington’s-banker argument. In fact I am. The idea that PBoC purchases of US government bonds is part of a discrete lending decision by Beijing, and that Washington must worry that one day Beijing might pull the plug on this lending, is almost utter nonsense. Chinese purchases of US assets are an automatic consequence of the trade balance between the two countries.
If the US wants foreigners to “lend” it more money, all it has to do is engineer a larger trade deficit. If it wants to reduce foreign lending, it must have a smaller trade deficit. That’s pretty much all there is to it. So warnings about what bad things might happen to the US if China stops buying US government bonds are no different that warnings about what bad things might happen to the US if its trade deficit contracts.
In other words: it depends. Most of us would assume that a contracting trade deficit is expansionary for the US economy and therefore a good thing. In that case fewer purchases of US dollar assets by the PBoC and other foreigners must also be a good thing because one is simply the obverse of the other.
But it’s not necessarily a good thing. It depends how it happens. If the US trade deficit contracted because soaring US unemployment caused investment to collapse (i.e. faster than nominal savings decline), it would undoubtedly be very painful for the US. But if the US trade deficit contracted because Chinese consumers imported more US goods, I think everyone would be pretty pleased about it, and the interest rate consequences be damned.