Pearls and Irritations

The two major economies, China and America, have severe structural imbalances between their savings and investment, which could significantly damage their medium-term growth prospects, with consequences for the rest of the world.

The media consistently reports that the USA is the world’s biggest economy, and China is the second biggest. However, that is based on using exchange rates to recalculate their respective GDPs in a common currency and is not a valid comparison.

Instead, the International Monetary Fund (IMF) reports that when properly measured in terms of their purchasing power, the Chinese GDP represents 18.4 per cent of the total world GDP, and the US GDP represents another 15.5 per cent.

But equally important, when added together the Chinese and American economies account for one third of world economic activity. Thus, if economic activity in either of these two major economies falters it inevitably can have severe consequences for the rest of the world, and perhaps particularly so in China’s case as it is a much more significant trading nation.

Right now, however, both these two major countries are facing severe structural challenges because of the severe and persistent structural imbalances between their savings and their investment. As will be elaborated below, in China’s case it is an excess of savings, while in the US which has insufficient savings, the opposite is true.

China

As has been widely recognised, the speed with which China lifted its people out of poverty since the reforms introduced by Deng Xiaoping in 1978 has been outstanding.

Essentially China’s growth model was founded on high savings and high investment. As Michael Pettis (a professor of Finance at Peking University) puts it: this model “succeeded because it closed, faster than in any other country in history, the gap between the existing level of investment and the level the country could productively absorb”.

But with the passage of time, the opportunities for such highly productive investment inevitably diminished. According to Pettis, China closed this gap in investment opportunities around 2006. After that China “should have switched to a different growth model, one that prioritized consumption over investment.”

Instead, as can be seen from Table 1 below, China’s national saving rate if anything increased further after 2006, implying a further fall in the share of consumption. With continuing high savings, the necessary demand to use those savings, and thus sustain employment, had to continue to come from high investment and net exports. In addition, foreign aid, such as the Belt and Road initiative also helped create demand for Chinese labour.

Table 1. Comparison of China and America saving and investment

All data are shown as per cent of GDP

But the continuing very high rate of investment, meant that the newest investments were becoming less and less productive and profitable. Again, as Pettis puts it:

“In the last two decades, investment in China has continued to rise as rapidly as ever, even as it has progressively generated less and less value for each dollar invested. Overall growth has increasingly been driven by asset bubbles, especially in real estate, and an unsustainable rise in debt.”

Essentially China needs to move away from its excessive focus on the supply-side of the economy. So long as China continues to prioritize investment and exports over domestic household consumption it is likely that household consumption will remain weak, leading to stagnation on the demand side of the Chinese economy.

Instead, as Zongyuan Zoe Liu (from the US Council of Foreign Relations) says, China needs “to focus on demand-side economic reform by shifting government policy to promote consumption over investment and by developing a more robust social welfare system.”

The USA

Interestingly, the US situation is almost the complete opposite of the Chinese. Instead, of a savings surplus the US has a structural savings deficit. As can be seen from Table 1, the US has had a negative savings imbalance relative to its investment rate for most of the last four decades.

This negative savings imbalance is also reflected in a negative current account imbalance which means that the US has been relying significantly on foreign capital inflows to support its investment demand. Even Australia which traditionally has relied significantly on US capital inflows, now invests more in the US each year than the US invests in Australia.

But what is also interesting is that the US negative savings imbalance is roughly accounted for by the borrowing requirement of the government. The US private sector (households and business) saves much the same as it invests.

It may be that the US can continue its present reliance on foreign capital inflows and run up more public debt, but it is a risky strategy, and increasingly so over time. Indeed, the biggest holder of US government securities is China, and China could react to US containment measures by withdrawing its support for the US bond market with potentially damaging consequences for the US economy.

In addition, the US bond market has been assisted by the fact that the US dollar is the main reserve currency used to make foreign payments. That encourages other countries to buy US bonds.

However, this may not last. The exchange rate for the US dollar is clearly over-valued with 1 Chinese yuan valued at 0.14 US dollar. Whereas according to the purchasing power comparison, a yuan should be worth 0.26 US dollar; almost double the exchange rate and a huge difference.

The future value of the US dollar is therefore vulnerable as countries have an incentive to shift to other currencies to make their international payments. Indeed, following the recent increase in its membership, the BRICS grouping of developing countries have agreed to make more payments using other non-dollar currencies, including most importantly the Chinese renminbi.

Furthermore, if there is a shift away from the US dollar, and a consequent fall in its value, it can be expected that the US central bank (the Federal Reserve) will try to counter this by raising interest rates in an attempt to stem the inflationary consequences. But that will inevitably result in a downturn in US economic activity, with consequences for the rest of the world.

Conclusion

The future of both the Chinese and US economies depends importantly on policy action to reduce their respective savings-investment imbalances.

The Chinese government’s 31-point plan released in July 2023 contains new policies to shore up confidence and support private enterprise, foreign invested firms and consumption. So China is at least making a start on necessary reforms.

However, the continuing failure of the US Congress to pass a budget lasting more than a few months, raises serious doubts about whether America even realises the nature of its challenges, let alone what is needed to resolve them. Indeed, all the signs are that America is becoming ungovernable, and that will only get worse if Trump wins the Republican nomination, let alone wins the Presidency.

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