Monday, June 28, 2010

China, Savings, and the Current Account Surplus

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.


  1. Controlling the financial system and the capital account is the foundation for Chinese state capitalism. Wishing-thinking or lobbying for the CCP to change this would have absolutely zero effect.
    The Chinese system is a tradeoff of high stability and high employment for low consumer purchasing power.
    By lobbying to raise the exchange rate, this puts a small dent in how this system performs by raising consumers' purchasing power, but doesn't alter the system fundamentally. In other words, it's more agreeable to the CCP than sacrificing real influence in financial markets.
    The rising exchange rate in the short term won't have extreme benefits for America, but neither will it impose extreme costs. In the long term, it may provide large benefits for both China and the US as consumers and businesses from both countries maximize the utilization of the goods and services from both countries.
    Mr. Williamson, just because you visit China once doesn't make you an expert in Chinese economics.
    For a good blog on Chinese economics, start reading Michael Pettis's blog China Financial Markets.

  2. The Chinese government is distorting terms of trade (and thus manipulating relative prices / comparative advantage) through its tax and transfer policy.

    I think it's OK to say we don't like that. Especially if we think market forces (left to their own devices) would have lead to "better" outcomes.

    Of course, we've distorted terms of trade as well via the clean air act and subsidized higher education. It's not clear we're willing to give those things up.

    Morris Davis

  3. Dear Mr. Anonymous:

    1. I'm not wishing or lobbying for financial reform in China. I'm just suggesting an alternative explanation for a set of observations.

    2. Where did I claim to be a China expert? However, I do at least have a PhD in Economics, which is a qualification that Michael Pettis does not have.


    Why should we feel we have a right to strong-arm the Chinese about how they distort their economy?

  4. But if there weren't, and hadn't been, such a large current account surplus for China, would the US be running such a large current account deficit, and would the US government now need to run such a large budget deficit to make up for the shortfall in aggregate demand?

  5. "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?"

    Working a lot harder" would imply that there are jobs!... here and not in China. Since we are currently suffering a lack of world demand, more consumption and demand from China would be welcomed by businesses in the rest of the world.

  6. Exactly. Keynesians seem to think that more jobs is always better. We can have more jobs and have a decrease in welfare.

  7. "Exactly. Keynesians seem to think that more jobs is always better. We can have more jobs and have a decrease in welfare."

    Only if we cannot figure out how to redistribute wealth to those that are unable to find work. Fewer jobs (or more leisure time for all) could be positive IF an adequate means of earning a living was present for all who want it. I'm in favor of redistributionist policies, extended unemployment insurance, more paid personal leave, a shorter work week, longer vacations, guaranteed health insurance, etc., that would make NOT working all the time more of a possibility for more people - but that's not the world we live in today.

  8. Actually, I was thinking about particular government policies that could increase employment, but make us worse off if they reallocate resources in an inefficient way. While I think the government has a legitimate role in providing social insurance (including health insurance), I would draw the line at some of the policies you want. For example, I don't think the government has any business mandating month-long vacations and 30-hour work weeks.

  9. Hi, I'm the anonymous writer that wrote the first comment. Sorry if I came off as too critical. And I don't mean to question your intelligence on economic matters. It's just that I've been reading many academic economic blogs that have discussed china in light of recent events. Many of them are quickly making Econ 101-type assumptions and conclusions because they have no extensive knowledge on how China works or what life is like there. I respect your blog postings, and picked a bad place to blow up.
    All the same, you shouldn't downplay too much Michael Pettis's lack of a PhD. He has a couple Masters degrees, years of teaching, and real-world experience in finance. I think it's worth hearing what he says.

  10. No problem. I agree that China is fascinating, and we can all benefit from learning more about it.

  11. Gary:

    "Working a lot harder" would imply that there are jobs!... here and not in China.

    I think these jobs would be in Mexico, Brazil or Vietnam, not in United States...