Source: Financial Times
Rising Chinese Consumption Won't Lead to U.S. RateGlobal markets seem increasingly concerned that a change in Chinese economic policy will soon force US interest rates higher. These concerns are mistaken.
During last month’s National People’s Congress, Beijing made raising the extraordinarily low consumption share of gross domestic product a top priority. If the plan succeeds, besides limiting China’s dangerous overreliance on investment to generate growth, it should also reduce the country’s massive trade surplus.
China’s savings rates are the highest recorded. If rising consumption forces the relative savings rate down just 4 or 5 percentage points – with no change in investment levels – China’s trade surplus would be wiped out.
Would this force US interest rates up? The worriers say it would. During the past decade China’s central bank has been the largest buyer by far of US government bonds as it recycled the country’s massive trade inflows. If a declining trade surplus forces down Chinese bond purchases, the worriers say, demand for US government bonds will plummet and US interest rates soar.
But there are two problems with this reasoning. First, China’s consumption share of GDP is unlikely to rise soon. Beijing has been eager to boost relative consumption since at least 2005, and during this time consumption has actually declined as a share of GDP from already alarmingly low levels.
It will remain hard to raise consumption by administrative means. The cause of low household consumption in China is the very low GDP share of household income, and constraints on household income growth are at the heart of its growth model. China has grown quickly, in short, largely because its institutional and financial systems transfer wealth from households to encourage and maximise investment growth.
Household consumption, then, cannot rise as a share of GDP unless those transfers are reversed, and one necessary consequence will be a sharp reduction in investment. But Chinese economic growth is heavily dependent on growth in investment.
Within China there is a vigorous and at times contentious debate about the need to reduce investment growth. But one thing is clear: because it will inevitably reduce growth sharply in the short and medium term, there is resistance from many key constituencies. So if the consumption share of GDP grows, it will take many years of much slower GDP growth before this happens to any significant extent.
But even if China is successful in the near term, there is a second flaw in the argument about soaring US interest rates. If the consumption share of China’s GDP rises, and is not offset by a reduction in investment, the resulting contraction in trade surplus will not necessarily mean deficient demand for US government bonds.
This may seem puzzling at first. If the world’s largest buyer of US government bonds suddenly stops buying, wouldn’t yields have to rise? Yes, but only if the reduction in Beijing’s purchases was not associated with a decline in supply.
If rising consumption forced a smaller Chinese trade surplus, however, and a corresponding decline in the US trade deficit, the supply of US government bonds would fall with the reduction in Chinese buying. Why? Because the expansion in the US fiscal deficit is a response to slow US growth and high domestic unemployment.
The US government, in other words, is expanding in Keynesian fashion to make up for weak domestic demand caused by household and corporate deleveraging. If something else could create the same demand, it would absolve the need for fiscal expansion.
A contracting trade deficit would be just that something else. Remember that declining trade deficits can be expansionary for the economy in the same way as increased government spending. In fact, because this kind of demand would be driven more by economic considerations and less by political ones, the former may well be a far more efficient way to expand domestic demand.
A drop in the US trade deficit would result in less fiscal spending as the expansionary impact of one would replace the expansionary effect of the other. In that case every dollar reduction in foreign net demand for US dollar assets (which is identical to the change in the current account deficit) could be met by one dollar less of US government borrowing.
So it is true that Beijing would be buying fewer US government bonds, but it is also true that Washington would be selling fewer. In the end Chinese rebalancing is an unalloyed positive for the US. Many things will determine future US interest rates, most importantly underlying economic growth and the Fed’s response, but China’s rebalancing is not likely to be an adverse factor.