To Save, or Not to Save; That is the Question.

To put it simply, the Global Financial Crisis (GFC) in 2008 was caused by a sub-prime mortgage crisis in the US housing market. There were inadequate regulations of US banks, and an imbalance in financial relations between borrowers and seller, all of which exposed underlying imbalances.

In the late 1990s, interest rates were lowered so that people with poor credit ratings were able to borrow in the subprime market. This increased the demand for housing in the US, leading to a building boom. In 2006, there was an oversupply of housing, which consequentially resulted in a drop in housing prices. Many people were unable to pay back mortgages up for renewal from this time at the prevailing higher interest rates. Ultimately, sub-prime home owners ended up owing more than the value of their home, and many defaulted on their loans – hence, the sub-prime mortgage crisis. Unprecedented integration and globalisation meant that financial markets globally took a hit (known as the GFC).

Specifically, economists have recognised China’s high saving levels and undervalued currency as contributing factors to the GFC. In 2008, China had a trade surplus of   ̵̴6% GDP, while the US had a trade deficit of   ̵̴6% GDP. Economic theory tells us that a trade surplus means a country is saving more than it is spending.  It is China’s view, along with many economists, that the solution to trade imbalance is simply for the US to save more and the Chinese to spend more.

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It’s more complex than that. First of all, we need to look at why China tends to save more. Figures released by the IMF (November 2012) show that China’s personal savings surpass every other country in the world, with an average rate of 52% compared to the world’s average of 19.7%.  Chinese households tend to be generally uncertain about the future. From inadequate social welfare, pensions, medical provisions, employment security and expenditure on education, there is a need for Chinese households to save in order to support themselves. Factors such as high housing prices, the one-child policy, disposable income levels and retained earnings of state-owned enterprises have also been linked to high savings rates. The bottom line is that saving levels directly impacts China’s current account surplus and the U.S. consumer deficit.

Is that enough? John Williamson (Institute for International Economics) highlights in his “Doctrine of Immaculate Transfer”, that it is not simply about spending imbalances, but also exchange rate policy.

It is widely believed that the Chinese currency, the Chinese Yuan, is undervalued. From the perspective of the US, China’s exchange rate needs to appreciate. Otherwise, China will continue to export heavily and US expenditure (on cheap Chinese exports) will remain high, continuing the underlying imbalance.

How do we know the Chinese Yuan is undervalued? Beyond China’s impressive economic growth, there are other factors causing upward pressure on the value of the Chinese Yuan. Firstly, strong export demand drives the value of the Chinese Yuan up, demonstrated by China’s significant current account surplus. Secondly, “hot money” is flowing into China, as speculators want to invest in China, believing that the Chinese Yuan can only appreciate with such promising growth prospects.

However, as the Chinese Yuan is pegged to the US dollar, the value of the Yuan is artificially kept lower than it would be otherwise. To keep their pegged rate stable, the People’s Bank of China must hold large reserves of foreign currency to mitigate changes in supply and demand.  China does this by selling the Yuan, or buying US dollars.  With more Chinese Yuan in the market, the value of the Yuan falls.

So, there are two lessons we need to take away from the GFC regarding global imbalances. The first is that the US needs to spend less and China needs to save less. The Bank of International Settlements has predicted that this may happen somewhat naturally, with China’s high savings rate likely to fall significantly as its middle class grows, workforce shrinks, the population ages and social security spending increases[1]. The second lesson is that China’s real exchange rate (for both imports and exports) needs to appreciate and reflect the Chinese Yuan’s true value (or at least closer to it), in order to help alleviate global trade imbalances.

[1] Bank for International Settlements (BIS) Working Paper No. 312, 2010