I just returned from Shanghai China where, as it turns out, one cannot access Google blog sites, which explains why I have been silent for a while. While there I learned a little more about the financial system in China, and have some things to say about recent issues related to China’s exchange rate policy and US deficits.
The savings rate in China is very high, and much of the high quantity of savings is accounted for by households. Financial institutions in China are not well-developed, with the banking system dominated by state-owned banks which lend on favorable terms to state-owned enterprises but give short shrift to private firms. There are significant barriers to entry for foreign banks, which account for about 2% or 3% of market share. A significant fraction of Chinese savings gets channeled through Chinese financial institutions into US Treasury securities, thus lowering rates of return on those securities. US (and other) firms, looking for high rates of return, invest directly in China, so some of the savings which exits China comes back as foreign investment. However, given the obstacles to foreign investment in China, there are plenty of would-be high-return projects that go without funding. The phenomenon of high savings in China creating a Chinese current account surplus and driving down real rates of interest in the world is sometimes called a “savings glut” (Bernanke coined this term I think). However, it is more useful to think of this as being associated with an underdeveloped, indeed an obstructed, Chinese financial system, which does not efficiently channel savings into investment.
Now, for a long time, Americans have been bashing China over its exchange rate policy. The idea seems to be that the nominal exchange rate is “artificially low” or “undervalued,” so that China is somehow forcing us to buy its goods at too low a price. In the meantime, as the argument goes, the Chinese are being far too frugal, in the process making our interest rates so low that our housing market goes crazy and causes us to go into a panic. Something should be done. After a long period of whining from the United States, China finally changed its exchange rate policy, but of course that’s still not good enough for our friend Paul Krugman.
What China does with its nominal exchange rate is of minor importance for the issues at hand here. Consider the following. Suppose that China had allowed its financial system to develop like its manufacturing sector. This would have involved a relaxation of barriers to starting up private banks and of restrictions on the activities of foreign financial institutions in China (to create a stable financial system, the Chinese would of course had to establish appropriate regulations to prevent excessive risk-taking). What would the result have been? Domestic savings in China would have been channeled into domestic investment in China, investment would have been much higher, and the current account surplus would have been much lower. Indeed, with a large enough investment boom in China, there would be a Chinese current account deficit currently, and the world real interest rate would be much higher.
What would things have looked like in the United States? Our government would be paying much higher interest rates on its debt and running a higher deficit, and foreigners might be thinking a lot harder about whether it was a good idea to lend to our government. We would also be running a current account surplus and working a lot harder to send goods off to China as inputs into their investment projects. Do you think we would like that world better than the one we are currently living in? Maybe Krugman would think we had struck the appropriate balance, but I think most of us in the United States would think that we were worse off.