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!
I might suggest that the rising trade deficit even after the appreciation of the currency is related to stickiness of existing business relationships. While business may plan to move to a new business relationship, the timing is slow. A selection process is required, capital investment is required, and the build out must be completed. This process could take several years.
As a result, there should be a significant lag between an exchange rate change and that change impacting the trade deficit.
Professor,
In medical research, one way to study the relationship between ethnicity and a certain health condition (eg. heart attack) is to look at the effect of the variable(s) on the end-point among immigrants and compare the results with findings from studying the native population. One can even design studies to compare first generation immigrants with their off-springs.
Are you aware of any studies in economics or social science looking at saving behavior among Chinese immigrants in North America or Europe?
“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”
A few of us have pinpointed that recently a few continental Chinese citizens did comment on this blog recently. This is an exceptionally rare and precious event. Let us hope that these two events are entirely disconnected.
On the subject of the post, I’d be glad to hear about “inflation expectations” in China. In view of the massive bubble, my take is that they should be much higher now that on an historical basis. Call me a sceptic but I find it difficult to understand that you can concurrently have a massively bubbling construction sector and a peacefully saving people. As long as inflation does not get in the way, why not?
The time of the defyingly cheap Asian import is long gone here in Europe. So I am impressed that China is able to controls prices so efficiently (2.7% we heard). Especially the local food pricing structure in such an environment. Sure this time is different!
“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.”
Exchange rates and real interest rates may not matter for the level of surpluses in the short term, but I would be willing to wager that it has a large impact on the quality of growth. Treadmill to hell anyone?
Michael,
Thanks for such a clear article.
Of course, by your model older people of relatively modest means (cash savings but few large assets) in the UK and US will correspond with the Chinese model (preferring higher interest/deposit rates), rather than the asset-owning classes (preferring lower interest rates).
I certainly observed that my grandparents were much happier when 6-12% was the normal on savings accounts and CDs.
Many thanks for your article.
I really like your analysis and keep following your site. I do have one comment:
Since the Chinese government usually respond slowly in terms of interest rate, is it possible that the real interest rate is negatively correlated with the published interest rate (deposit rate). That is, when the CPI is on the rising, the central bank will try to catch up by adjusting the interest rate, but they are always lagging. That way, it is easier to explain why people consume more when interest rates goes up. Because people do not really trust the published CPI in china which tends to under-estimate the inflation, when interest rate goes up, it is actually a good indication that price are going up. As a result, people tend to horde things.
The target saving explanation can be part of the reason, but I really doubt if that is the main reason.
Thank you for yet another very insightful piece.
I have a few questions related to the effect of balance sheet mismatch on the difficulty of performing a yuan revaluation and increasing consumption in China.
Is there any available data or model allowing us to compare the magnitude of balance sheet imbalance with respect to GDP for China today and Japan in ’85 ? Or at least magnitude of credit expansion with respect to GDP?
The current levels of credit expansion in China, occuring before revaluation, wouldn’t make things more difficult, than in the case of Japan in 1985? How much more can China expand after revaluation?
Is the current trend of commodities hoarding in China at the same time a form of attempt of wealth preservation and inadvertently (or by design) an additional method of dollar sterilization? (which translates in a temporary trade deficit and also alleviates some of the pressure for revaluation)
In the unlikely event of a managed attempt of yuan revaluation process, which gets out of control, can China count on the same level of international assistance, Japan had in ’85, to rebalance its economy?
Michael Pettis
While currency appreciation may have little effect on trade could it not have a strong psychological effect on those who are heavily leveraged to Chinese asset prices? (Tipping Effect?)
Mr Pettis
Thanks for addressing the downtime problem. Welcome back online, assuming that you are posting under your admin’s nomer. Insightful, particularly about the perception of interest rates, not that Asian people haven’t known that dirty little secret. It’s an Asian wide phenomenon broadly speaking- having gone from stuffing mattresses to banking it.
Currency does matter of course but until the barriers to investing elsewhere are removed, status quo will likely remain. Even if the property speculation measures kick in , there is little chance of anyone really having much alternative, talking of course about the claustrophobic middle class.
Should consumption shrink, look for more “subsidised” spending packages.
The real interest rate that matters for depositors and borrowers is not based on current inflation, but on expected inflation. If the RMB is going to appreciate slowly, import is going to get cheaper. In the same time export is going to become more expensive and more goods are likely to stay in China. Building more capacity is going to exacerbate this problem. RMB appreciation should bring an enormous downward pressure on expectations for inflation and it is the most logical way for the Chinese government to fight inflation.
The real danger for Chinese consumption is in severe decline of their real estate prices. A serious portion of Chinese savings is put as a down payment for houses and apartments. 20%, 30% and even higher percentage down payments are not rare. If and when prices start to drop, the equity (the savings) of many new real estate owners will be wiped down and their marginal propensity to consume will slump. Strong RMB appreciation could soften the crises, but then PboC and Exporters will have to take a big hit.
I’ve read somewhere that 80% of Chinese have own homes .. wouldn’t that mean that real estate is also a large portion of household wealth? I guess it would also explain China’s auto purchases which are huge despite low income growth. Widespread real estate holdings could mean a different type of wealth effect.
Michael, its interesting to see that the Brazilian economists see the same fact pattern as in Brazil. Part of this real estate frenzy in China might just be related to the fact that bank savings are an utter joke as a way of preserving wealth: with negative real rates people just get crammed into “hard assets”, not unlike in Latin America in much of the 70s and 80s. Raising rates may be a good idea though it would be hard without some revaluation. I saw something of interest recently in the FT where Guo Shuping suggested China develop a junk bond market. Do you think this is an effort to get some of the junkier credit off bank balance sheets and do you think this would be a good idea?
Hi Michael,
from your argument, it seems interest rise will not curb inflation, but increase consumption that puts on further inflation pressure. Then what other mechanics out there could possible contain the high inflation pressure? (apart from rise reserve requirement)
Arguably, even rise reserve requirement, it can only have impact on the business side (if business are moderately/significantly indebted), then it appears Gov has almost ran out of options to contain inflation, unless go for the planned-economy way?!
Hello professor Pettis:
I am a keen regular reader of your blog and have been reading your excellent and insightful articles for almost a year. This is my first to leave comment.
I agree with most your points and there is one point at which I feel quite perplexed or even kinda scared. As you’ve pointed out that we are going to see a repeat of the post-2005 experience, does it interpret that while the China trade surplus keep bulging the real estate market will flow the same pattern too? Will the Chinese housing price draw another sky rocketing curve as what it has been doing since 2005? With low interest rate and moderately expanding credit policy despite the recent clampdown on the real estate market, I really suspect if the market is heading for another round of bullish cycle. Can you shed some insights on this issue? ‘cause as an average Chinese city dweller living by renting, I am very concerned with upward fluctuation of housing price and the subsequent developing trend that it follows.
Thank you very much and I am looking forward to reading your thought provoking ideas.
Excellent discussion, audio, with Hu Shuli talking with former Japanese Minister Heizo Takenaka on China rebalancing which gives a Japanese take on what faces China. (note: “SDL” is SDR to English speakers)
http://english.caing.com/2010-04-19/100136425.html
“The real danger for Chinese consumption is in severe decline of their real estate prices. A serious portion of Chinese savings is put as a down payment for houses and apartments. 20%, 30% and even higher percentage down payments are not rare. If and when prices start to drop, the equity (the savings) of many new real estate owners will be wiped down and their marginal propensity to consume will slump. Strong RMB appreciation could soften the crises, but then PboC and Exporters will have to take a big hit.”
Sounds like they have an incentive to prop up real estate prices…
Thanks for a very interesting post.
“After the yen began rising in 1985 in Japan, … , policymakers … engineered a reduction in the real interest rate and an expansion in credit.”
For China, it is easy to see how the government could do this. What tools did Japan use and did those specific measures create trade friction or were they unrecognized (by the US) at the time? Do you think the US gov is savier now? Your comment insightfully shows that other tools can be (stealthly) used to manipulate imbalances (i.e. the corollary to currency manipulation is regulatory manipulation).
I am writing my thesis on US-China trade and found this article very interesting especially in considering relative price (US-China) changes. For example, my VEC analysis predicts a relative increase in Chinese CPI prices as a result of a nominal exchange rate appreciation of the RMB. I was wondering what sources you draw upon for the reasoning behind this post and if they could help explain the predicted relative price decrease that I have found evidence of.
On one hand, I expected a nominal appreciation to be associated with a relative decrease in Chinese prices as imports become cheaper (as well as some domestic goods through the cheaper intermediate good imports). Also, I expected this effect because Chinese exporters have been found to sacrifice profit margins (i.e. prices) in the face of a nominal appreciation. On the other hand, it is possible that this may be more of a short term effect and in the medium term demand shifts to domestic goods, increasing domestic prices.
Does this sound plausible to you?
Professor Pettis: Many thanks for your earlier reply to my query concerning the role of the informal financial sector in China. Could you suggest references to books or articles in this area?
As a “ball park number” you mention that perhaps 25 % of all loans come from the informal sector. If these loans carry rates of say 50 – 100+ % a year, this implies that “weighted effective” interest rates are indeed much higher than nominal bank lending rates.
If so, the general perception that Chinese “interest rates” are way out of wack with “nominal GDP” needs further nuances — as well as their influence on savings-investment decisions. best regards James
good summary on the latest in the never-ending Greek bailout saga and what it could mean for the rest of the world:
http://www.goldalert.com/stories/Gold-Price-Drops-Euro-At-11month-Low
“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.”
Not disagreeing but perhaps more to the point, declining interest rates (on loans) in the US leads to more consumption because debt is the preferred method of financing consumption. Declining interest rates (on deposits) in China leads to less consumption because consumption is funded with money left over after savings commitments.
Michael,
I was thinking about this issue in relation to the U.S. It’s always been the case, at least since WWII, that lowering rates spurs spending. But I wonder if that’s changing? First, I think it’s necessary to divide Americans into two groups, the proverbial grasshoppers and ants. Average household debt is extremely high here, but in fact, only 45% of households have a mortgage, and only ca. 40% carry credit card debt. The free-spending grasshoppers have hit a brick wall, they’re the ones carrying much of the debt and can’t afford to take on new debt no matter what the rates.
Meanwhile, the ants, always saving for tomorrow, spend less when their savings earn less, just like the average Chinese consumer. And as the bulging baby-boomer cohorts have aged, their spending is more likely to be effected by the return on their savings than by the cost of borrowing.
Lowering rates to increase spending worked only as long as households were willing to carry ever-greater amounts of debt.
Prof,
That’s exactly why I advocate to focus on trade imbalance rather than currencies. Trade imbalance is something easily measurable and agreeable by all while currencies under or over-valuation is determined by a mix of arcane mathematics, some national pride and lots of politics, which means we are unlikely to reach any consensus. Set the mutually agreeable goal, set the time-frame and let China decides the course of action to rebalance the trade; any shortfall to be compensated by pre-determined Yuan appreciation on quarterly basic. Personally, I would rather China inflates the way out to rebalance through subsidies removal especially on environmental factors and wages hike. Cheap Chinese products are mainly due to internal cost structure under-pricing, to which the correct remedy is to reprice production factors.
Interesting summer coming up, what with trouble potentially brewing in Europe, bubbles in the air almost everywhere and China having to deal with some long term “issues” – what’s the bet that China may just get away with minimal scrapes should the European situation really turn nasty?!?!
not news but apparently the blues are trying to retake some research ground on SWFs , a possible filler for Brad Setser’s “interesting” take on the SWFs ?
but they are quite far from being impressive.
good try though.
ok, this is happening with disturbing frequency today, forgot to paste the address on the previous comment. sorry mr pettis, not trying to take up space on your blog. http://oxfordswfproject.com
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.Compare ISAs
Creative article. Your theme is interesting. This is the most well-thought-out, wide and agreeable post.