The Virtues of ‘Over-Savings': A Post-Crisis Reflection on the Chinese Economy

October 12, 2009 By Qing Wang Hong Kong Mapping the future course of policy action. The developments in the Chinese economy since late 2007 have been truly remarkable. The economy completed a six-month journey from the end of ‘overheating' in 1Q08 to the beginning of a ‘hard landing' in 4Q08, as the global financial turmoil broke out. China managed to become the first of the major economies to recover from the ‘great recession' as a result of powerful policy responses without precedent. With a strong recovery now underway, attention is increasingly being paid to the potential consequences of the super-loose monetary and fiscal policies and the attendant exit strategies. It is an issue of asset allocation, given China's high level of national savings. China's national savings rate is about 55% of GDP - 19% is contributed by households, 11% by the government and 25% by corporate sector. There are only three forms in which national savings can be deployed: 1) onshore physical assets; 2) offshore physical assets; and 3) offshore financial assets. Onshore physical assets are formed through domestic fixed-asset investment. Offshore physical assets are formed either through overseas direct investment or by obtaining ownership of existing offshore physical assets through M&A by Chinese residents. Offshore financial assets are formed either by the central bank's official FX reserve accumulation or private portfolio investment under free cross-border mobility (i.e., no capital account controls). A recurring macro theme: high investment, high growth and low inflation. High savings provide sufficient funds to finance high growth of domestic investment, which, in turn, delivers high economic growth. This high growth, backed up by high domestic savings, tends to, ceteris paribus, generate deflationary instead of inflationary pressures. Specifically, when investment is initially carried out, it is part of aggregate demand (i.e., moving the demand curve to the right) and thus tends to put upward pressure on prices. However, investment will eventually add to production capacity and thus substantially boost supply (i.e., moving the supply curve to the right). The net impact is that, despite high economic growth, inflationary pressures will likely remain subdued. In a high-saving environment, any inflationary pressure is unlikely to last long, as the supply response through investment will likely be fast, given that abundant funding due to high saving is readily available. Offshore financial assets are primarily in the form of FX reserves. China's offshore financial assets are primarily in the form of central bank's FX reserves, which account for 70% of China's total offshore assets. This has largely reflected capital account controls, such that domestic residents are not allowed to freely invest offshore. However, offshore financial assets in the form of official FX reserves do not imply genuine deployment of domestic private savings offshore, as domestic liquidity - which corresponds to the part of savings that would have been invested in offshore physical or financial assets by the private sector had there not been capital account controls - is created when the central bank accumulates FX reserves, but stays inside China. Persistent asset price inflation pressures. On the one hand, abundant domestic liquidity is created as a result of FX reserve accumulation, and the demand for financial portfolio investment is strong; on the other hand, domestic capital markets are under-developed, and there is insufficient supply of securitized investment products. In China, 85% of financial intermediation is through the banking system, while the stock market accounts for only about 10%, and the bond market is virtually non-existent. The unbalanced demand-supply in capital markets is a key reason for the rich valuation in China's stock market. As a discounting mechanism, the still-small stock market in China is ‘over-burdened' to price in the long-term ‘bright future' of the entire economy, such that it can easily get into a bubble situation in a short period of time, especially when investor sentiment turns buoyant. China's high savings is a generational phenomenon. China's high national savings is a generational phenomenon. The high savings ratio is primarily a function of such secular forces as China's demographics, largely shaped by China's ‘one-child' policy and slow adjustment in households' spending habits against the backdrop of rapid economic growth. The ‘one-child' policy artificially lowers the dependence ratio sharply in a much shorter period of time in China than in other countries, where aging is a natural process. The low dependence ratio substantially raises the savings ratio. While households' incomes increase rapidly in line with overall economic growth, personal consumption habits may take years and even decades to change. This results in a high savings ratio, which is often attributed to ‘cultural factors'. While other structural factors, such as lack of social security and corporate governance at SOEs, may also contribute to the high savings ratio in China, their impact is either marginal or an indirect reflection of the abovementioned secular forces. The whole picture: persistent asset price inflationary pressures to be a norm. Reflecting the ‘virtues of over-saving', the Chinese economy has experienced, and will likely continue to experience, high growth and relatively low inflation, with a cushion against external real or financial shocks, as long as the high savings ratio persists, in our view. In this context, persistent asset price inflation pressures will likely become the norm instead of the exception in the Chinese economy, constituting the most important and a constant macroeconomic challenge to policymakers for years to come, in our view. Top policy priority: contain leverage with a view to minimizing systematic risks. In an ‘over-savings' economy like China, managing persistent asset price inflation pressures will likely become a more important policy objective than controlling conventional CPI inflation or promoting economic growth for years to come. However, since the conventional monetary policy tools are not best suited for managing asset price inflation, the pressing task is instead to minimize the attendant systematic risk in the event of a bursting asset price bubble. The damage from a bursting asset price bubble with limited leverage is more manageable. To this end, ‘containing leverage' in the economic system will likely become a key policy objective. This will entail strict mortgage rules for homebuyers, strict restrictions on margin trading in the stock market, and strict capital adequacy requirements for banks. Also, in this context, preventing one-way bets on the renminbi exchange rate becomes important, as strong expectations of renminbi appreciation will induce hot money inflows, which is yet another form of leverage employed by foreign speculators. In a similar vein, there is a need to push ahead with asymmetric liberalization of capital account controls to induce capital outflows and discourage capital inflows. Outbound capital account liberalization under initiatives such as the qualified domestic institutional investor (QDII) and qualified domestic retail investor (QDRI) programs should help to satisfy domestic savers' need to own offshore financial assets directly, thereby slowing the pace of FX reserve accumulation by the central bank and domestic liquidity creation. Controls over inbound capital flows - especially short-term portfolio investment - should, however, be either maintained or removed only gradually. Otherwise, these inflows contribute to exacerbating asset price inflationary pressures stemming from domestic savings and further complicate the policy challenges. Structural reform agenda: price deregulation and development of capital markets. With macroeconomic and systematic risks under control, prominence should also be given to structural reform measures that help to improve the quality of investment. While ‘over-savings' helps to deliver good headline figures, such as high growth and low inflation, the capital generated by ‘over-savings' should be allocated efficiently. To this end, liberalization of administrative controls over interest rates and the price of energy and other key natural resource commodities should be implemented without delay, in our view. Domestic capital markets - including both equity and fixed income markets - should be strengthened to address the asset price inflationary pressures by increasing supply of securitized products to meet the rising demand for investment opportunities. Structural reform agenda: what about consumption-promoting measures? Boosting domestic consumption by lowering the savings ratio has been made a key policy priority, especially since the global financial turmoil broke out. However, if China's high national savings is a generational phenomenon, there is not really much policy room to help lower the ratio meaningfully, in our view. In particular, strengthening the social security system and corporate governance at SOEs may lower the household savings ratio, but it may not be able to effectively lower the national savings ratio. Any consumption-boosting structural reform would likely be modest and have a marginal impact. Aggressive policy measures to lower the savings ratio irrespective of its generational nature would be counter-productive, in our view, by making a welfare system too generous to be affordable by a still low-income country like China. In fact, many of the relevant policy proposals being discussed in this regard should be viewed as measures to address income disparity instead of aiming at increasing consumption at the aggregate level, in our view. Near-term policy implications. We expect the current policy stance to remain broadly unchanged towards year-end and to turn neutral at the beginning of 2010 as the pace of new bank lending creation normalizes from about Rmb9.5-10 trillion in 2009 to Rmb7-8 trillion in 2010. Policy tightening in the form of an RRR hike, base interest rate hike or renminbi appreciation is unlikely until the middle of next year, in our view.