Courtesy of Michael Pettis’ s China Financial Markets
Sorry to regular readers for my blog’s being out of commission for much of the past week, but apparently it has created too much traffic for the host, so without giving me any warning they pulled the site. We came up with a temporary solution and will move to something more permanent soon. Since I supposedly own the domain (this is what Charles Saliba, who takes care of these thing for me, tells me – I have no idea what that means), there will be no need to change the address of my blog.
Part of the reason this has taken so long to fix is that during the whole period I was at a conference in Sao Paolo, where I was lucky enough to share the stage with a number of luminaries, including Pedro Malan. Needless to say the subject of China is hot in Brazil. There is a great deal of soul-searching about the impact of Chinese commodity purchases on Brazil’s economy, along with a great deal of hope and dread.
One topic that people found especially interesting was the discussion on why China’s savings rate is so high, especially when I discussed it as one of the consequences of financial repression. At least four different economists told me, separately, that my account of Chinese imbalances and the forced rebalancing process reminded them of Brazil in the 1960s and early 1970s, and the difficult rebalancing process of the late 1970s and the “lost decade” of the 1980s. Brazilian economists seem to understand very quickly the relationship between financial repression and savings. No surprise here – I suspect quite a few Japanese economists do too.
But it is not always easy for many others to see how it works. For example in the US, unlike in China, we are used to seeing savings as positively correlated with interest rates. When interest rates rise, in other words, the savings rate tends to rise and the consumption rate decline, although this doesn’t always happen so mechanically.
One explanation for this relationship is that the interest rate is the reward for postponing consumption. Rising interest rates increase the reward, and so in response, households reduce their consumption and increase their savings. The obverse is that the interest rate is the penalty for anticipating consumption, and because rising interest rates make it costlier to borrow to finance consumption, they reduce consumption and increase savings (borrowing is negative savings).
This explanation for the positive relationship between the interest rate and savings rate makes it a little surprising, then, that in China and in certain other countries, especially those typically included as examples of the Asian development model, rising interest rates are often associated with higher, not lower, consumption. In places like China it seems that as interest rates rise, households may actually increase their consumption rather than their savings, and as interest rates decline, savings rise and consumption declines.
Why? Last year, just after the PBoC cut the deposit rate early in the year, one of my students told the class an interesting story that may at least partly explain. She said that the reduction in the deposit rate had upset her aunt and uncle because they had been saving money so as to have a certain amount for their twelve-year-old son for his university education. Every month his mother put some part of the family’s household wages into an account at the bank for that purpose.
How much should she save?
Obviously she had done a fairly straightforward calculation to figure out how much she needed to add to this account every month. The amount of money she had in the account earned interest, of course, which was added to the total savings. She calculated whatever was needed in addition to the interest income to achieve her final target, and this amount was taken out of the family wages every month and added to the account. What was taken out of wages, of course, shows up in the national accounts as the family’s savings rate. The rest is the family’s consumption rate.
When the PBoC lowered the deposit rate, this meant that if she expected to reach her target she would have to match the decrease in interest income one-for-one with an increase in the amount she saved out of monthly wages. In their case, then, a lower deposit rate was necessarily associated with a higher savings rate – and the amount this particular family consumed out of total wages declined.
This should suggest that some of us, and I would argue perhaps nearly all of us, don’t really think of the interest rate as what we get paid to postpone consumption. We are more apt to think of savings in a different way.
We want to have a certain amount of wealth to pay for expected expenses, retirement, holidays, emergencies, or whatever, and we save in order to achieve that target. In that case we save to manage a targeted increase in our wealth, and unexpected changes in our wealth will affect our savings rate. This is called the wealth effect, and I suspect the wealth effect, more than anything else, drives savings. In the US, for example, US consumption as a share of GDP tends to be correlated with the performance of stock, bond and real estate markets. Most Americans have a significant part of their savings in the form of stocks, bonds, and real estate, and when these markets rise, Americans feel richer and spend more out of their monthly income. Their savings rate declines and their consumption rises
What does all this have to do with interest rates? Typically when interest rates decline, asset markets rise. This makes Americans feel richer, and so they increase their consumption, even if their wage and salaries don’t rise. This I suspect is why in the US and many other rich economies we associate declining interest rates with a decline in savings.
But not in China. The financial system and the way people save in China, and many other developing countries, especially in Asia, are very different. First, deposit rates in China are not set by the market. They are set by the PBoC to achieve specific policy objectives – for example to determine the profitability of the banking system, in the way explained by last week’s post.
So when the PBoC announces a change in the deposit rate, it reflects current policy decisions, and not a change in underlying interest rates that affect the value of assets. Second and more importantly, most Chinese have the bulk of their financial wealth in the form of savings deposits, not in the form of stocks, bonds and real estate. By the way those that do have lots of other assets tend to be much richer, so changes in their wealth have less effect on their consumption behavior
The general wealth effect in China, then, is mostly about the impact of interest rate changes on the perceived value of bank deposits, and not on stock and real estate markets, and I would argue that consequently the impact of interest rates on the wealth effect is the opposite in China as in the US. In other words rather than lower interest rates being associated with increased wealth, as in the US, it is associated with reduced wealth.
Deposit rates and wealth
Why? Because we all have an implicit rate at which we discount money, say our inflation expectation, and this has an important side effect when we think about our wealth. My sense of my wealth is partly affected by the amount of money I currently have in the bank, but also by the rate at which I discount the earnings on those deposits over the period in which I have targeted the amount of total savings I want to have. If the deposit rate rises with no change in my implicit discount rate, I immediately feel richer, and if it declines, I immediately feel poorer. If I have a lot of savings in the bank, my total income is very positively influenced by the deposit rate.
In that case the wealth effect works very differently in China than in the US and many other developed countries. Declining interest rates in the US usually (but not always) mean that Americans feel richer because the market value of their homes, stocks and bonds has risen. Declining deposit rates in China usually mean that Chinese feel poorer because the return on their savings relative to their implicit discount rate has declined.
This is probably why interest rates seem to have the opposite effect on consumption in the two countries. In China if interest rates (or, more accurately, deposit rates) rise, it increases the wealth of Chinese households by shifting wealth from the banks and users of capital to households. In effect rising deposit rates increase household income significantly, and so increases household consumption.
Of course we must distinguish between nominal and expected real rates. If Chinese households believe that future price increases are greater than the deposit rate, their real expected return will decline, and they will feel poorer and so reduce their consumption. I suspect this is what is going to happen this year. CPI inflation is rising, and deposit rates have not, so as the real deposit rate declines there is likely to be downward pressure on Chinese consumption.
This, by the way, is why I don’t think a small increase in the value of the RMB will have much apparent effect on reducing China’s trade surplus. Real interest rates, already too low, are declining as PPI and CPI inflation rise. This will have two important effects. By reducing Chinese household wealth, it will put downward pressure on consumption, and by reducing the real cost of capital for borrowers it will increase investment in capacity. The resulting upward pressure on production and downward pressure on consumption could easily swamp whatever impact on the trade surplus a slightly more expensive RMB might have – which would increase real household wealth by lowering the cost of imports and reduce the implicit subsidy to the tradable good sector.
More interestingly, let us assume that the RMB rises and real interest rates decline by exactly the necessary amount to keep the trade surplus stable. Will anything have changed?
I think so. It seems to me that a rise in the RMB hurts all exporters and a decline in real interest rates helps all users of capital who have direct or indirect access to bank loans. A combination of the two might have no net effect on the trade surplus, but it will cause a shift away from labor intensive exporters towards capital intensive exporters – which is probably the opposite of what Beijing wants.
After the yen began rising in 1985 in Japan, and after the RMB began rising in 2005 in China, policymakers in both countries engineered a reduction in the real interest rate and an expansion in credit. Perhaps not surprisingly the trade surplus in both cases grew, allowing a number of critics of appreciation to conclude, bizarrely enough, that the value of the exchange rate didn’t matter, and, in what seems to me very inconsistent, that Japan and China should have strongly resisted appreciation.
But all it really proves is that currency is not the only thing that matters. In fact anything that shifts the relationship between production and total demand, of which consumption is an important component, matters.
With rising inflation, stable interest rates, and massive credit expansion, I suspect we are going to see a repeat of the post-2005 experience. The RMB will slowly appreciate, but the trade surplus, at least during the rest of 2010, will not decline, and may even rise. And hordes of commentators will exclaim: See, the currency doesn’t matter!