After three weeks of traveling it is good to be back in Beijing, even though now I have to work through the mountain of very fattening mooncakes my very kind students have given me for Mid-Autumn Festival Day. While I was away it seems that there were a lot of rumors in the market about changes in the banking system. Are Chinese banking deposit rates about to be deregulated, or relaxed, and if so what will that mean?
Before discussing those rumors, I wanted to get some more general context on the issue of interest rates. In a very interesting September 16 speech on Japan’s post-bubble experience, Bank of Japan Masaaki Shirakawa argued among other things that “protracted low interest rates play an important role in preventing an economic downturn, but, at the same time, they tend to delay adjustment in excesses accumulated during the period of bubble expansion. In addition, they also tend to delay the rejuvenation of businesses.”
I think this is a very important point. By effectively taxing net depositors in the banking system (households) and using the proceeds to subsidize net borrowers (SOEs, large manufacturers, real estate developers, infrastructure investors, local and municipal governments, etc.), artificially low interest rates can prop up growth by increasing investment, but they do so by simultaneously encouraging overinvestment, especially in capacity, and discouraging household consumption. In China this process worsens the already horrendous domestic imbalance.
China needs to raise its interest rates, but to do so will be painful in the short run because too much Chinese investment and too many Chinese borrowers can only survive thanks to the enormous capital subsidy. Raising rates too quickly, in other words, will cause a surge in financial distress and rising unemployment. On the other hand, failure to raise rates will simply increase the domestic imbalances and raise the cost ultimately of any adjustment. This is not an easy trap from which to escape.
Toaster ovens, anyone?
And it is easy to see some of the consequences. Saturday’s Financial Times has what was for me a fascinating – if perhaps little noticed – article on a recent warning by the CBRC to Chinese banks:
Chinese regulators have publicly warned the country’s banks to stop chasing deposits by offering customers extravagant incentives such as prizes, free travel, paying children’s school fees and even providing jobs for relatives.
The China Banking Regulatory Commission issued a notice on Friday saying “a minority” of banks had resorted to such tactics since the start of this year to attract deposits from clients. It said banks and individuals involved would be strictly punished.
China’s central bank sets a ceiling on the interest rate that Chinese lenders can offer depositors, as well as a floor on rates that they can charge borrowers, a practice that avoids cut-throat competition among banks and guarantees them a healthy lending margin.
But even some senior Chinese bankers have attacked the perverse incentives this strict control creates. The chairman of Bank of China published an article in which he fretted about the unsustainable nature of a system that encourages banks to lend as much as they can in order to maximise profits.
Those Americans old enough to remember banking in the days before the passage in 1980 of Depository Institutions Deregulation and Monetary Control Act (DIDMCA) will know exactly what the Financial Times is talking about. Before 1980 the Federal Reserve Bank set the maximum interest rate US banks could pay on deposits (the once-famous Regulation Q).
For a variety of reasons during the inflation of the 1970s the deposit rate became too low and created a series of widening distortions in the capital allocation process. Among other things American banks, in order to compete for deposits but unable to do so by offering higher interest rates, resorted to a wide variety of non-monetary incentives – most famously offering toaster-ovens as gifts to anyone who opened an account. Depending on the size of your account you could also get free holiday packages, bicycles, and tons of other things – anything but money.
Chinese banks seem to be doing the same thing. Prevented legally from offering higher deposit rates, they are trying to increase their deposit base by providing either non-interest compensation (gifts) or they are illegally offering to pay higher rates.
Bank incentives
Why should banks want to pay more for deposits? Because banking in China is a money-making machine that basically transfers income from depositors and tax payers to bank shareholders. The mandated difference between the maximum deposit rate and the minimum lending rate is so wide that banks make a huge profit on the spread as long as they don’t make risky lending decisions, and the way to avoid risky lending, of course, is simply to lend to SOEs and local governments (both of which are implicitly guaranteed ultimately by the household sector, via cheap deposits and taxes). This is the main reason why inefficient SOEs are flooded with cheap credit and the very efficient small and medium enterprises are starved of capital.
Towards the end of the section I cited the Financial Times article referred to an August 25 OpEd piece published Xiao Gang, the Chairman of the Bank of China, in China Daily. I found the article in some ways astonishing, but surprisingly little-discussed, and it is well-worth reading.
Although he didn’t come out explicitly and say that the recent lending boom is a big problem, Xiao Gang does say that it “neither assures the long-term sustainable development of the banking sector nor satisfies the need of a balanced economic and social structure.” Pretty strong words, I think, although as is often in the case of China, a little more circumspect than what might be said elsewhere.
Xiao’s basic point (the article is called “Don’t blame it on the government”) is that Beijing should not be held responsible for the recent lending spree.
As a chairman of a bank, I have never received any instructions from the government to lend money to any project. All decisions relating to business were made either by the board, or by the management.
Instead he argues, the incentive structure within Chinese banks is distorted in a way that makes every bank eager to gather in as many deposits as possible and to maximize the loan book.
Interestingly, the banks have revamped the remuneration schemes top-down, closely linking their employees’ emoluments and branches’ expenses to performance, in particular, to revenues and profits. The emoluments usually consist of two parts: one is the basic wage related to different posts, and the other is performance-linked bonus that generally accounts for 50-70 percent of the total emoluments.
Those who do not advocate issuing more loans (and therefore make more profits) are, of course, not so popular within banking circles. While expanding their loan portfolios, Chinese banks are smart enough to take the risk-averse approach and to focus on lending to large State-owned enterprises (SOEs). These SOEs often enjoy monopoly in their sectors and quasi-government credit ratings. This can, in turn, explain why Chinese banks have steadily improved their asset quality and reduced their non-performing asset ratios.
Market rumors
Since, in my opinion, the main incentive structures are the too-wide spread between the lending and the deposit rate and the socialization of most credit risk, and these are basically set by the regulators, I would argue that the government is indeed responsible for the lending boom, but technically Xiao is right. Notice that among other things he is also indirectly acknowledging that the “improvement” in the bank loan portfolios is largely a consequence of socializing the losses. This doesn’t mean that fewer bad loans are being made. It just means that the losses will be borne not by the banks but by the government (i.e. households).
All of this leads us to the topic of the day – rumors that there will be a change in the regulations in China that set the maximum deposit rate that banks can legally offer. In a Friday email my Shenyin Wanguo colleague and former PKU student Chen Long summarizes for me the recent rumors:
Last week it was widely said that Chinese authorities would allow banks to raise the household deposit rate by up to 10%. Actually this is not very surprising news. Xia Bin, a member of the PBoC monetary policy committee, first talked about the deposit rate floating experiment in Liaoning Province on Aug 30th.
This was backed by statements from the Chairman of the PBoC’s Shenyang branch on Aug 31st and by Governor Zhou Xiaochuan’s speech on September 9. On September 16, a CBRC official also said that the interest rate liberalization process would accelerate.
Many in the markets believe that this measure will come out very soon and some even say that the State Council has approved it. The only uncertain thing is when it will be announced and what is the detail.
One day earlier, Chen Long had sent me the following email:
Professor Li Daokui, a member of PBoC monetary policy committee, said in an interview that deposit rate hike is necessary as negative real interest rates reduce household income.
CCTV broadcast his interview and this became the top news today because of his role in the PBOC monetary policy committee. However, the monetary policy committee is only a consulting group for PBoC officials. They cannot decide monetary policy.
Professor Yu Yongding and Professor Zhou Qiren, former and current members of monetary policy committee, have long advocated an interest rate hike, but to little avail. In a forum held in Peking University in June, both of them argued that Chinese interest rates had long been too low but they also declared very clearly that they cannot decide the policy making.
What I think is more possible to happen is the floating or relaxing the deposit rate. Xia Bin, another member of the PBoC monetary policy committee, talked about the deposit rate floating experiment in Liaoning province and that was backed by Chairman of PBoC Shenyang branch on Aug 31st as well as Governor Zhou Xiaochuan’s speech last Thursday.
China still has many instruments with which to control the price level, like the loan quota, the money supply and open market operations. If Beijing really wanted to lift rates, they would have done it several months ago when they oversaw a possible CPI rise. Considering that CPI growth is likely to slow down in Q4, they have little incentive to do it. Deposit rate relaxation, a more gradual reform measure, will be their preferred option.
So will we see a change in the rate banks are allowed to pay depositors? There are many good reasons to expect this. Aside from distorting banking incentives and encouraging cheating, very low deposit rates are, at least in my opinion, the single biggest form of hidden tax that transfers resources from the household sector to subsidize producers and investors, and so are also the single biggest cause of the imbalance between domestic production and domestic consumption (I calculate that, thanks to artificially low interest rates, 5-10% of GDP is transferred every year from households to net users of capital). Raising the deposit rate is a necessary part of rebalancing, and I am glad to see that Chinese commentators are increasingly making this argument.
Not so easy to do
But it is not as easy as all that. If you raise deposit rates, what do you do about lending rates? On the one hand, you can raise lending rates by an equal amount so as to keep the spread constant. This, of course, will do little to address the distortions in incentives, and by mandating such a profitable spread, it doesn’t change the low eagerness of banks to make riskier loans to entities that are more economically viable.
More importantly, I have argued many times that a very large portion of new lending has gone into toxic investment – in excessive infrastructure, excess capacity, in real estate development – that is only viable by virtue of the implicit debt forgiveness that automatically accompanies artificially low interest rates. Any serious attempt to reduce this debt forgiveness by raising interest rates will almost certainly see an increase in financial distress. In some cases it would lead to stopped projects and bankruptcy, and so to rising unemployment. That makes it difficult to raise the lending rate significantly.
On the other hand you can leave lending rates unchanged. This would probably improve the incentive structure – if bankers were no longer able to mint gold effortlessly thanks to guaranteed profits determined by the regulator, presumably they might be more likely to make more profitable lending decisions. It would also raise household income.
But what would it do to bank capital? The regulators have made it very clear that they want Chinese banks to increase their equity bases. One possibility is for banks to issue equity in China or abroad, but I doubt that there is anywhere near the appetite, especially for the smaller banks who are likely to have much of the garbage debt. A second possibility is for the kind of inane round-tripping that was much-discussed until recently but has, I hope, been shelved. Government entities like Central Huijin can borrow money from the banks and use the proceeds to buy bank equity. Of course this does little for systemic bank capital.
Ultimately the main source of capital for the banks is likely to be retained earnings. The very wide spread between deposit and lending rates has guaranteed bank profitability – albeit at the expense of the struggling depositor – and has done more to raise equity capital than anything else.
If the regulators raise the deposit rate without raising the lending rate, in other words, they are undermining their own professed determination to raise bank capital. Presumably raising bank capital is necessary in order to deal with an expected surge in non-performing loans.
Will they do this? I doubt it. My guess is that we might see some tinkering with deposit rates at the edge, but that deposit rates cannot be deregulated and will not be allowed to rise enough to make much of a difference. Any change is likely to be small.
Raising interest rates is all the less likely, by the way, in the context of the increasingly tough trade conversations around the world. Remember that an undervalued currency is one way of getting a trade advantage, but repressed interest rates are an even more powerful way.
If China is forced to raise the RMB by any significant amount, it will probably want to counteract this by expanding credit and reducing, not increasing, real interest rates, which is what China did after 2005 and Japan after 1985. As those two examples make clear, lowering the real cost of capital to counteract an appreciating currency will create a whole different set of problems.
This all goes to show that there is no easy way of eliminating the deep imbalances and distortions in the Chinese financial system. It will have to be done slowly and determinedly, and will require many years of a very cooperative global environment. Unfortunately I am very pessimistic about our chances of seeing any of these conditions, especially the latter.
———-
Before closing, let me suggest a few pieces of news worth noting. First, Martin Wolf at the Financial Times has a piece (“Wen is right to worry about rebalancing”), which purely out of vanity I will recommend.
Second, this week the People’s Daily had two articles, one aimed at the US and one aimed at Europe, warning of the consequences of trade war. It is clear that there is a lot of concern in China, but it is not clear that everyone in Beijing understands what are very legitimate complaints from China’s trading partners. I was at a meeting yesterday between a senior EU trade representative and someone close to Beijing policymakers and I was frankly surprised (even shocked) both at the hectoring tone of the Chinese representative and at his total failure to understand the trade issues, or at least to understand the European view.
China is right to be concerned about protectionist measures abroad, and has some very legitimate complaints, but unless it understand the very equally legitimate complaints over Chinese trade-related policies, it is hard to imagine that we will arrive at any sort of optimal solution. As an aside I wonder what will be the effect of the announcement yesterday that Larry Summers is leaving the White House. My impression is that he has been a real bulwark against rising US protectionism, and his departure may change the tone in Washington substantially.
Third, the Telegraph published a very interesting story about some very strong and angry statements by the former British chancellor. “The euro has been permanently damaged,” they say, “by Germany’s failure to intervene swiftly during the sovereign debt crisis earlier this year, Alistair Darling has said in an unusually frank attack.” As part of the overall deterioration in global trade that I have been writing about for two years, I have always expected that China-bashing was soon going to be rivaled by Germany-bashing. In a world of contracting global demand, the high savings high surplus countries are going to be lambasted for predatory policies. I am not sure there is much that can be done to reverse this process.
Forth, Marshall Auerbach has a post on Naked Capitalism (an excellent blog that I read regularly) that forcefully describes the criticism of Chinese policies on the global economy, albeit with an unfortunate and unnecessarily incendiary title.
And finally, Li Hong at People’s Daily states the Chinese position as to why China’s behavior has not been predatory but has in fact prevented global economic conditions from getting worse. The fact that the Auerbach and the Li pieces have almost no overlap indicate how difficult this “debate” is likely to be.
Happy Mid-Autumn Festival, everyone. My amazingly-talented-at-everything graduate student Gao Ming is taking me off to dinner now — and i hope he doesn’t have mooncakes.
Hi Michael, do you know you have been hacked? That is the only explanation I can think of why the last two posts that came down to me via RSS were titled as follows:
“From: “Buy Online Viagra, Cialis, Levitra”
Subject: Generic Imitrex”
and had this text:
“generic imitrex”
interspersed though-out the text. That is two posts in a row, so maybe no one else has told you? Or maybe I am the only RSS subscriber?
Clayton
Thanks Clayton, but I am very, very aware of the problem as quite a few people have written to me about it. It was actually worse two weeks ago, with Viagra advertisements appearing everywhere, but my colleague Charles Saliba has been trying to fix the problem. For now it seems only the RSS feeds are still affected, but the hacking has apparently been fairly sophisticated. We will fix it, but it has’t been easy. Sorry for the inconvenience. I am not sure the hackers are ever likely to generate a lot of Viagra sales from my blog but, needless to say, they haven’t offered me a cut of the profits, or even free samples.
Clayton and Michael, I guess even the hackers are calling for more stimulus
Glad to see the site up and running again.
Great blog. I clicked on the link for your book, but the sidebar just went blank and didn’t take me anywhere. Using firefox.
Alot of interesting reflections in this post. Maybe you could break them into pieces and post more often.
I have surplus viagra for anyone suffering a deficit.
Thanks for another interesting post.
I am not seeing those bad headings when reading this in google reader.
Beth
Prof Pettis – As always – Thanks for the great work. I am surprised to hear about the “hectoring tone” from China about trade issues to the Europeans. I had thought PBOC would be helping support the Euro currency in some fashion(outright currency purchase and or bond support) to protect reserve value estimated at 26% of $2.45 Trillion as a dead Euro helps noone in global economy and hurts many. Would this not be a concern for them?
2nd – your thoughts on this Reuters article “China allows insurers to invest in private equity, real estate” http://www.reuters.com/article/idUSTRE6841UO20100906
Thanks
Hi Michael,
I’ve noticed as well that more US economists are now calling for a further stimulus, whether fiscal (on the left), monetary (on the right) or both. Isn’t it also the case that if policymakers take extraordinary steps such as QE2 or ARRA2, they will keen not to see the stimulus leaked abroad through negative net exports?
It seems to me for example that Paul Krugman has been right about the bond market, deflation etc, and he has also been tough on China in his recent columns. He hasn’t to date linked them together and drawn the conclusion that stimulus would be much more effective if combined with a tougher policy towards China and others.
I did notice a comment piece in the FT recently that made the link, by Thomas Palley: http://blogs.ft.com/economistsforum/2010/09/plan-b-for-obama-on-the-economy/#more-11616
The rss has been working fine for me. Have not received any advertisements.
Hi Prof Pettis!
Welcome back to Beijing and the best weather of the year so far! Personally i am not a moon cake fan (mine normally get “re-given” to other people!)
Thank you again for a very comprehensive entry! Also thanks for drawing our attention at the end there to some very interesting pieces and articles! I will spend the rest of the afternoon doing some reading!
Xiao Gang is writing regulary for the China Daily now (I think it is more a column than an OpEd). Expect one on Local government financing vehicles soon.
I think his main point was that the lending boom last year was not mandated by the government. Although the interest rate spread encourages lending and is indeed mandated by the govt. , I don’t know if this spread was created by the government just during the crisis or not (having not got any historical data on interest rates in front of me). I think one of the main causes for the 2009 lending boom was the removal of lending quotas by the authorities, so maybe we could argue that the government unleashed the system that they set up (by removing quotas and maintaining the interest rate spread to lend). At the same time, stimulus policies created a lot of demand for lending at various levels as projects were authorized and created as a response to the crisis. Along with those lending incentives within the banks etc, there was a perfect storm of pro-lending conditions!
Anyway, enjoy the weather, the holiday, the moon cakes, and coming soon, the next holiday!
Professor Pettis, I have an off topic question, more out of curiosity.
The commenter “Equus” gave some well-documented, contrarian and original replies on the following site and article.
http://theburningplatform.com/blog/2010/09/15/when-japan-collapses/
His knowledge and the fact that he can read Japanese and Chinese led my thoughts to you. Am I right? Don’t tell me if you don’t want to.
Once again thanks Michael, you deliver by far the most valuable insight that I have come across on this very wide web. I hope super-hawk Glenn Stevens at the RBA reads you!
Prof Pettis
Hope the mooncakes have gone easy on you (binging on suagr can have nasty consequences).
Will the PBoC gie up its stranglehold on bank deposit rates, hmm, well , don’t see any cow leaping over the moon, least not this side of the world.
Read Auerback’s piece via the link. Part of it made some sense:
If China were to revalue significantly now they would increase the risks of more financial disequilibria largely because of the impact likely to be experienced in China itself, which could dwarf the situation that occurred in Japan, during its post bubble collapse.
That has signs of disaster written all over it.
Towards the end is where he starts sounding a little delusional : Would it be a disaster for the U.S. if U.S. consumers had to pay a little more for their goods, but more of those goods might be produced once again back home, thereby reviving the U.S. industrial base?
and
f it leads to trade conflict, bear in mind that in a depressed world economy, surplus countries have a lot to lose from such a conflict, while deficit countries may well end up gaining.
Firstly, does anyone really think the goods that have shifted production base from the states to China (or from any other part of the world to China) are going to shift back? That is wishful thinking, they will simply shift to bases where the costs will be lower, eg bangladesh. It will not reduce the imbalances, merely shift it geographically.
As for trade war, hmm, to think that clear winners and losers will emerge is quite optimistic, a destabilised China (and even Germany) will do nothing for the world economy nothing short of grief. Whilst cutting edge technology may be regarded as discretionary consumption, that may not be the case for mundane things like shoes(even your tech genius is unlikely to pad around barefoot, however new age and alternative he/she may be). It remains to be seen who exactly will be hurt in a trade war. Besides, let’s not forget that much of the manufacturing sweatshop ops are run on the behalf of huge (western) retail concerns like Walmart – squeeze prices higher, dampen consumption and things don’t look that good for the markets. Unless you can figure out a way to squeeze “mercantilist” countries and spare major retailers simultaneously.
There are valid points on both sides of the divide but in a world that has not quite figured out how to decouple, one should be very careful about stomping on that Achilles Heel till all are sure that nerve does not run in their direction.
hi, Michael
Just read about rising wage of Chinese labors. If the reduction of trade surplus is inevitable for China, rising wage may be a better option than currency revaluation.
What do you think of it?
speaking as a brit, a pro-european and not a labour party supporter, i must say that alistair darling is someone i have enormous respect for. he broke rank in august 2008 to say that the world faced a crisis as bad as the 1930s – something that caught the british public by surprise and caused him a serious run-in with his own boss. i think he also deserves more credit than brown for the excellent handling of the financial crisis in the uk. he has now retired from politics, so his comments reflect true opinion rather than any kind of posturing. i would however caution that the telegraph is an anti-european paper, so its presentation of darling’s comments may need to be taken with a pinch of salt.
Hi Micheal, I’ll add my thanks to the list and confirm the other positive sentiments above. Every where I look on the internet everyone is struggling with one big macroeconomic issue. Where are we headed with inflation? Are we likely to see sustained high inflation, hyper inflation or deflation? I’ve recently read “this time it’s different” by Reinhart and Rogoff. Their conclusion after studying two centuries of financial data seems to be that governments usually default either explicitly (by defaulting on foreign or domestic loans) or by devaluing (by printing money and causing inflation) their currencies or both.
At the moment there is lots of talk about competitive currency devaluation. Recently we have seen a renewed down trend in the US dollar. Japan is intervening to weaken it’s currency. The Australian, (commodity currency) dollar is nearing it’s all time high against the US dollar. Gold is continuing it’s bull run against all currencies. People like Marc Faber are 100% certain that the US will default by means of high inflation. People like Mish Shedlock are seeing deflation and are certain it will get worse. You talk about looming trade wars and the disorderly unwinding huge imbalances. Technical analysts look at the long term chart for oil and see a huge head and shoulders and wonder what that could mean. I guess my question boils down to what is the likely inflationary outcome of a global trade war with deficit countries targeting surplus countries with tariffs not to mention the possibility of a break up in the Eurozone? Under the gold standard during the depression there was much hardship and significant deflation especially in the US and in fact the US came of the gold standard at one point before going back on to it. What could happen in a pure fiat currency world?
Very interesting. I’m thinking worldwide trade is collapsing rapidly. It’s to the point that it can’t be hidden anymore in the US. Europe doesn’t seem to be in any better shape. Maybe gold will be discovered in Mexico and start a gold rush. Then China can sell picks and shovels and the US can provide grubstakes.
Michael,
I believe that Geithner has been busy convincing Congress to authorize trade tariffs on China. This will devalue the dollar, which, I believe, is one of Geithner’s goals. Do you have any opinion as to the effect on U.S. Treasury bonds should Geithner get his wish?
Chris Whidden, for that pun you should be barred forever from this site.
Brazil, actually for the past two years there have been increasing complaints about an adverse attitudinal change. This worries me of course because of the historic precedents. If you read magazines issues from the late 1920s or late 1980s (I confess I often do), you will see stories about an incredible surge in arrogance, hectoring and bad manners from Americans in the former case and Japanese in the latter. It seems that in the late stages of an unsustainable growth spurt we humans tend to throw caution, intelligence and humility to the winds, and of course that just makes the eventual adjustment that much harder and that much more gleeful to our neighbors. As for your question about insurance companies getting into private equity, I confess I have a very bad feeling about private equity in China. It reminds me of the early 1990s when the head of one PE company, my former boss Pedro-Pablo Kuczynski, complained to me that there were more PE firms in Latin America than there were small and medium-sized companies. The fact that princelings are no longer interest in being investment bankers – which was all the rage ten years ago – but are instead pouring into the PE business, gives me a very worried feeling about what it takes for a PE investment to be successful.
Blair, actually Krugman has in fact made that point several times. He has argued that a widening trade deficit dilutes the employment impact of fiscal deficits.
Houhui, yes, it is the quota, and how strictly it is enforced, that determines the extent of new lending. Left on their own the combination of cheap deposits, wide deposit-lending spread, socialized credit risk, and short-sighted local leadership would inevitably see bank balance sheets double every year.
Geert, I am not sure if I understand your point, but if you are asking if I am “Equus,” the answer is no. In fact I disagree with most of what he says.
Judy, I often hear that the US can no longer produce the kinds of stuff that it imports from China but I am not sure I agree. Because of basically free capital China produces a lot of capital-intensive stuff that the US produced as little as ten years ago, and I don’t see why it cannot simply do so again – after all the surge in the US trade deficit didn’t really occur until just after the 1997-98 crises (not a coincidence, as I have argued before). The US production of steel, cars, chemicals, advanced aluminum, and many other things has been decimated in the recent past, and it seems that it wouldn’t be so hard to revive them just as quickly as they were taken down. By the way, even if the US could not produce anything China exports, it wouldn’t really matter. What matters is how things adjust globally, not bilaterally. If the US buys fewer widgets from China but is forced to buy them from, say, Mexico, the impact on Mexican wages, currency, and interest rates would automatically cause a rise in Mexican imports from abroad (assuming of course that unlike China Mexico did not intervene to prevent the adjustment), and mutatis mutandi it would result in an increase in US exports to Mexico or somewhere else. Remember that a reduction in one’s country trade surplus must be matched by an equal but opposite shift elsewhere.
Litz, yes, although I am not sure how seriously I take the claims that Chinese wages are set for a long rally. If wages rise too quickly it will have the same impact on financial distress as if the currency or interest rates rise too quickly. I hope next week I will be able to do an entry on how the various types of adjustment (wages, currency, and interest rates) play out – that is who wins and who loses
Simon, my working assumption is that over the next few years the world will be suffering from overcapacity and deficient demand growth, so I am not sure I am as worried about inflation as others are. In most cases, the ends of these long “globalization” cycles were characterized by deflation. The exception of course was the period of the 1970s and the 1910s (WW1), so are we more like the 1970s, or the 1930s/ 1870s/1830s? I would say the latter, but who knows?
With the world desperate to export capital, and no one eager to import it, I do not expect interest rates to rise unless we see inflation, but I am not too worried, at least for know, about inflation.
Professor Pettis
I think land and buildings are part of production cost,so overall they are also quite critical when manufacturers are having boardroom debates on where to site their proposed production plants,with the ever escalating property prices in China,irt may also be a factor when we consider whether some of those manufacturing activites identified by you do have a chance of shifting back to USA fr China.
What is yr comment on this point?Thank you.
As a free market believer, I do think the distortion in China financial markets is the single most important factor for the current imbalance. Chinese government officials have strong incentive to achieve a high GDP number. Exploring the economic of scale with cheap capital is the easiest way to generate very fast growth in a very short period of time, which serves the political interest of the government officials.
My question is, given the existing gap between saving and lending rate, would it create a permanent trade surplus irrespective of the currency rate? Over investment (i.e. the gap between production and consumption) seems to be a structure problem. How can we expect the up and down of currency rate will change the gap?
http://www.cato.org/pubs/journal/cj28n2/cj28n2-7.pdf
This is an interesting paper with a different angle.
Quote:
” In these economies, an independent monetary policy is unfeasi- ble, undesirable, or both, for at least one of the following reasons: (1) the pass-through of exchange rate movements to domestic prices is high; (2) the interest rate channel of monetary policy transmission isweak; (3) balance sheet mismatches in the banking system could trig- ger a financial crisis in the absence of hedging instruments; and (4) the central bank lacks the capacity or independence to target infla- tion. Under the principle of the “Impossible Trinity,” countries have to give up one of the following targets: monetary independence, exchange rate stability, or financial market integration. For most developing countries, the choice is clear.”
Well, I think the market gave me my answer today, at least as far as equities go. They seem to love that bill going to the House floor. http://noir.bloomberg.com/apps/news?pid=20601087&sid=aKhqJoFF8pIk&pos=8.
“China needs to raise its interest rates, but to do so will be painful in the short run. . . On the other hand, failure to raise rates will simply increase the domestic imbalances and raise the cost ultimately of any adjustment. This is not an easy trap from which to escape.”
I spoke with Geng Xiao, Director of Columbia Global Centers / East Asia in Beijing about this issue and he recommended that China allow some increase in interest rates and, at the same time, some appreciation of the RMB and some inflation, which would — to some extent, he argued — mitigate volatility. Do you think that’s a reasonable solution?
And in terms of the spread between lending and deposit rates — according to IMF data the spread in China is fairly similar to the spread in the U.S. (see http://futureofuschinatrade.com/fact/quarterly-interest-rates-us-and-china-1993-2010) Your thoughts?
Molly Castelazo
FutureofUSChinaTrade.com facilitator
Litz, raising the value of the currency itself changes the amount of both investment and savings by shifting income from exporters to consumers.
Molly, I think the purpose of that chart was to show correlations, not to measure the actual spread. For example they use US Prime as the proxy for the US lending rate, but most good borrowers borrow at well below Prime, or at least they did in my day. The correct way to measure the spread is to compare the deposit rate with the lending rate to a risk-free borrower, either on a matched maturity or a weighted average maturity basis..
Michael, your point to Litz on the effect of raising the value of the currency shifting wealth to those who are effectively short dollars (consumers and many domestic focused industries) from those who are long dollars (exporting firms and their financial backers) is a great point that many people just don’t seem to get. I engaged with Scott Sumner over this on his blog, and he kept coming back to the savings rate as the sole cause of the Chinese CAS, which from an accounting identity is true, but that’s not causation.
Obviously, you’ve laid out the policy measures that the Chinese government uses to force the savings rate up. But, drawing the connection between those policies and the manipulation of the real exchange rate some how is hard to convince those have a more traditional view of trade policy (tariffs only). However, isn’t manipulation of the nominal and real exchange rate is central diverting income gains from productivity increases away from households and back to the corporate and banking sectors?
I don’t think we should be surprised at the hectoring. Something seems very wrong with China’s internal politics now, what exactly, an outsider has little chance to understand. Fomenting nationalism, blocking rare earth exports, and demanding apologies after diplomatic concession, is a sign of internal power struggles perhaps, or the rise of military factions in the government.
“Fomenting nationalism, blocking rare earth exports, and demanding apologies after diplomatic concession, is a sign of internal power struggles perhaps, or the rise of military factions in the government.”
Very odd indeed. I was wondering if China was stumbling into a real awareness of the world as a whole for the first time – it has been an inward looking empire. And now, it’s reaching out and up and so are resentments.
China wants what it wants, and doesn’t want to be bothered with what anyone else wants. Chinese self-regard has soared. Why should they be bothered, when they know they’ve got the MNC’s over a barrel and are headed towards being the largest economy?
I hope these ridiculous and petty conflicts don’t turn into something real. There is a carelessness to Chinese behavior I find disturbing.
Purple
The rare earth issue proved to be not a targeted block, but a blanket, so it is not comparable to Russian Gas / Oil or before that Middle Eastern Oil. There are plenty of rare earths across the globe, it is just that China had until recently priced them out of business, i imagine that not only prices but strategic pressures are now causing a lot of the facilities to re-open. The whole apology demand thing is indeed worrying, and recommend you check out a nice piece on Foreignpolicy.com called “what China learned from putin” which is out now.
hi, Michael
My question is rather, if we still keep the peg in place, whether changing the exchange rate along(say one-off yuan revaluation) without correcting the domestic distortion(financial repression) will result in a balanced trade? Would we see a collapse of Chinese trade surplus in the short term and a rebound of the surplus once the shock is over? The domestic structure problem, i.e. the over-investment and lack of consumption would not change with a stronger Yuan.
Yuan peg at any given exchange rate is entering a currency union with US. Once the peg is done, the factor price will adjust accordingly (China’s factor price did adjust in the past). It will not create distortion pre se. I think this is the reasoning of Mundell behind his support to the peg regime(and Euro as well). And I don’t think it is possible to find a “right” exchange rate in a peg regime.
However, I may agree with you, as the experience of Eurozone has shown, if the states of a currency union do not harmonize their economic policy, the imbalance will ultimately occur.
Prof Pettis
Need to clarify some points:
1.Not saying that the USA cannot produce those “widgets”. It has done so in the past and can certainly revive them. Thing is, free trade means movement towards optimum pricing and supply/demand patterns which often plays out as least cost and profit margins that depend more on quantity than price. Can the USA accept producing at levels of cost that are comparable to those at which China and other lower cost producers are producing? At the end of the day, corporations (some of whom have benefitted from shifting production to lower cost bases) need to decide whether they want to incur a higher cost and pass that onto the consumer, not all of whom can afford higher prices.
2. There is a perception that seems to be going around that China is not doing enough to raise living standards, by suppressing consumption through a combination of factors like wage suppression and suppressed growth for its currency. It may be that I’m naive, but here’s my 3 cents worth. It’s not that China does not wish to raise living standards for its workers, the question is how(without destabilisation)? It has not gone up to the same point of the curve as the USA is in right now. What took the USA almost a century to develop, China has had to undertake in a few decades. The one question people round the world have to ask themselves is, would a destabilised China benefit everyone?
3. In your Mexico example, I see a skirting of the issue. The fact is unless those manufacturing bases shift back to the USA, instead of to other lower cost manufacturing bases, there is no resolution of the deficit/surplus problem, it has just shifted its geographical location. No matter whose account those surpluses shift to, the deficit lands back on the USA, unless the counterparty is going to increase consumption to a level that conveniently negates the difference. What are the chances of that adjustment coming through at the speed at which it’ll prevent political and social dissatisfaction from growing?
One of the factors that work against the shifting of those bases back to USA is that of labour cost. Unless you see the average American worker accepting a wage similar to those in lower cost countries or corporations willing to shear off a significant portion of their profits, that is not going to happen. Social expectations is one thing that economics cannot effectively deal with.
It’s not that the world does not want to consume at the level/rate at which Americans are, the rest of the world mostly cannot afford to do so. Not that the resources available on this planet is going to be able to support the rest of the world consuming at that rate. And I’m not particularly in the green camp either.
Thanks Micheal. In my thinking I tend to lean towards another deflationary episode similar to 2008. But who knows how central banks would react to that? The political environment for banks may be more adverse in the future. With more people reading about financial repression on blogs like this we may see more financial activism. Over the weekend I read (more like skimmed through) Long Walk to Freedom by Nelson Mandela. I think financial repression is more subtle and insidious than the overt political repression suffered by black South Africans under Apartheid. It took eighty years from the formation of the ANC in 1912 until free elections were held in about 1994. I wonder what kinds of evolutions or revolutions, if any, are in the future for those suffering financial repression.
http://en.wikipedia.org/wiki/African_National_Congress#History
If Lark is right, and not just China but everybody “want what they want” and “don’t want to be bothered by what everone else wants” we are in for WWIII. In a different way that we are used to (no missiles or bullets), but equally damaging to the previous World Wars.
Personally I think that what we have at hand right now can only be fixed if we were to have one sole currency. I know this academically might be an stupidity, but mentally we have to accept that this is our planet and we are all in the same boat. If we don’t adopt a Win-Win strategy soon, we are going to start diverging exponentially and coming back together will require an ever increasing effort.
I refer to this dilema as: one back slash today, or ten tomorrow. You (politicians) choose. The decision would be irrelevant to me, should it not be my back that will bear the blunt of the decision. The problem is that no politician wants to tell its citizens that we are up for a huge personal effort, maybe its because no citizen wants to hear it.
Thanks for your insightful articles Prof. Pettis.
Un afectuoso saludo.
Prof Pettis, unfortunately I have to disagree with this analysis. Deposit rates, in real terms, are generally negative across countries and across time. Also, if savers are given more incentive to keep money in bank deposits, consumption would be lower (even an added 200bp on Rmb65bn of deposits will not make a diff) and banks will have even more cheap lendable resources.
The root cause of banks’ large spreads is actually on the lending business. If you look at the CP market, that prices credit some 200-300bp lower. I would argue that borrowers are hurt by an artificial floor on lending rates.
The solution lies in creating capital market alternatives for savers such as money market funds. Unfortunately the banning of trust product issuance takes us away from that.
Hope you are well