For China, economic rebalancing very specifically means raising the GDP share of household consumption from its astonishingly low level of 36%. Low household consumption is mainly caused by the very low GDP share of Chinese household income, so the key to rebalancing is to get household income in China to rise faster than GDP.
But this will not be easy. Chinese growth has been underpinned by a series of hidden transfers from the household sector to investment and manufacturing.
There are three main transfer mechanisms: an undervalued currency reduces the real value of household income by raising the cost of imports while subsidizing exporters; wage growth that lags productivity growth reduces labour’s share of production while subsidizing employers; artificially low interest rates set by the central bank (PBoC) tax net savers (the household sector) while subsidizing users of capital (manufacturers, infrastructure investors, governments and real estate developers).
INTEREST RATES
Much has been written about the first two transfer mechanisms, but it is probably the third that is most responsible for generating China’s extraordinarily high savings rate and its trade surplus. Artificially low interest rates transfer every year 5–10% of China’s annual GDP from households to capital users. Not surprisingly, the household share of national income has dropped while that of borrowers has risen.
Raising the household income share of GDP, then, will require eliminating and even reversing these transfer mechanisms, of which the most important is low interest rates. But while it is one thing to suggest raising lending and deposit rates, it is another thing altogether whether the PBoC actually can raise them – at least enough to matter.
One of the problems with a repressed financial system, especially one with rapid credit expansion, is significant capital misallocation supported by borrowing. In an increasing number of cases, it is only artificially-low borrowing costs that allow these investments to remain viable. Even if the PBoC wanted to raise rates, it would not be able to do so without exposing how dependent borrowers are on artificially cheap capital.
Take the most obvious example, the PBoC itself. The central bank officially has about $2.5 trillion in reserves. Reserves are funded with an equivalent amount of renminbi liabilities, which makes the PBoC vulnerable both to changes in interest rates and the value of the currency.
In fact, there were already strong rumours last year that the 20% increase in the value of the renminbi against the dollar in 2005–08 seriously eroded the PBoC’s capital base. The problem occurs not just because of the currency mismatch but also because the PBoC requires repressed funding costs to prevent a larger negative carry on its portfolio.
How so? Because PBoC foreign currency assets probably earn 3–4%, maybe less, while the renminbi funding cost is roughly between 1.5% and 2.5%. This leaves the PBoC with a net positive carry of 1–2%.
If the renminbi appreciates by as little as 2% a year, in other words, the PBoC must run a negative carry. Every further 1% increase in interest rates, or additional 1% rise in the value of the renminbi, erodes its capital by at least $25 billion.
If over the next two years China sees a combined appreciation and interest rate increase of 10% – the absolute minimum that China must do to slow down the worsening domestic imbalances – the PBoC’s net indebtedness would rise by over $250 billion, or roughly 5% of the country’s GDP. These kinds of number quickly add up.
And of course it is not just the PBoC that has this addiction to low rates. Many years of cheap borrowing have created a dependency on low interest rates among state-owned enterprises, local governments and other creditors (not to mention the banks themselves), all of whom are directly or indirectly funded by long-suffering households.
|
|
Repressing the interest rate is the equivalent of granting hidden debt forgiveness, and many borrowers depend heavily on this hidden debt forgiveness to remain solvent. They would be unable to repay if rates rose to anywhere near a reasonable level – at least four to five percentage points higher taking out the overinvestment and repressed consumption consequences of financial repression. In that case raising interest rates to levels high enough to reduce China’s investment misallocation and to allow households to raise their consumption levels would come, in the short term, with a rise in bankruptcies and government debt levels.
So what can the authorities do?
THE CHOICES
If Beijing raises interest rates quickly, debt and bankruptcy will surge, and growth will collapse – although the eventual rebalancing of the economy might happen much more quickly. If they don’t raise interest rates, they can keep growth high for several years longer, but the amount of reserves and misallocated capital will continue rising, making the eventual cost of raising interest rates even higher.
The risk in that case is of a Japanese-style stalemate, in which for many years the authorities are forced to keep rates too low, because they simply cannot countenance the alternative, and during this time consumption growth continues to struggle. Here it is worth quoting the September 16 speech on Japan’s post-bubble experience, by Bank of Japan governor Masaaki Shirakawa, who 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.”
Finally, if the PBoC raises interest rates slowly, growth will slow and China will still suffer many more years of worsening imbalances, until rates are finally high enough to begin reversing the imbalances. But for this strategy to work, China would need a highly accommodative external sector – China’s domestic imbalances require high trade surpluses to absorb the huge gap between what it produces and what it consumes.
So far the authorities do not seem to be seriously considering raising interest rates, and if the US successfully pressures them to revalue the currency, they will be even less likely to do so.
In fact, as in 2005–08, when the currency last revalued, they are likely to engineer a reduction of real interest rates and a rapid expansion of credit. This will counteract the contractionary effect of revaluing the currency: competitiveness lost because of a higher currency will be counterbalanced by competitiveness gained by lower costs of capital.
This of course will also put more upward pressure on the trade surplus, allowing China to continue to use the external sector to absorb excess capacity. Of course it will also sharply increase the asset misallocation problem – as Japan demonstrated after 1985 when, in response to the appreciating yen, it reduced interest rates and expanded credit.
Interest rate policy in China has to choose between rising bankruptcies or rising misallocation of capital. Even ignoring political pressures, this isn’t an easy choice. At best it will require a great deal of sympathy and cooperation from abroad – something which is likely to be in short supply over the coming years as trade relations continue to deteriorate.
Michael Pettis is a finance professor at Peking University and a senior associate at the Carnegie Endowment