Chinese recycling and US interest rates

Chinese recycling and US interest rates

APR 15TH, 2011 BY MICHAEL PETTIS

http://mpettis.com/2011/04/chinese-recycling-and-us-interest-rates/

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.

FOR MORE GoTo   http://mpettis.com/2011/04/chinese-recycling-and-us-interest-rates/


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