by Michael Pettis
My friend Mark Williams sent me last week a reference to a very interesting paper written by Malhar Nabar, an economist at the IMF. The paper is called “Targets, Interest Rates, and Household Saving in Urban China” and in it Nabar tries to measure the impact of changes in the real deposit rate on changes in Chinese consumptions levels.
How do interest rates normally affect the savings and consumption rate? The consensus view, of course, is that there should be a negative correlation between interest rates and consumption. In other words when interest rates rise, households should save more and so consume less out of current income.
Why? One reason may be that savings are simply postponed consumption, and we are willing to postpone consumption if we are paid enough to do so. The more you pay me to save in the form of a high interest rate, in other words, the more I save out of current income, and so the less I consume. The same thing happens, by the way, when rising interest rates cause the cost of consumer financing to rise, and so discourage the use of credit cards.
There is another reason why this may be the case. Typically we associate rising interest rates with falling stock, real estate and bond prices. If most of our wealth consists of those three kinds of assets, then higher interest rates should be associated with a decline in our wealth, and because we feel poorer, we reduce our consumption rate.
In both cases rising interest rates are assumed to bring declining consumption and higher savings. This relationship seems to be supported by the data in many countries.
I am nonetheless a little uncomfortable with the first explanation – that as you increase the reward for postponing consumption, households save more. I find it hard to believe that people really think this way about savings, and if they did, it seems to me that unless there were an enormous preference for liquidity, in any country in which deposit rates were negative in real terms (i.e. households are paying, not getting paid, to postpone consumption) consumption rates should rise to 100% or more.
This certainly isn’t the case. In China, for example, deposit rates are seriously negative and have been negative for many years, and yet the household savings rate is nonetheless very high. In fact it seems that, as a rule, countries with repressed interest rates have higher, not lower savings rates.
What’s more, I have seen US historical data that suggests that when interest-rate declines have coincided with falling, not rising, stock and real estate markets (as they have recently), the savings rate usually rises rather than declines. In other words households care mainly about their wealth, not about the reward for postponing consumption.
Which explanation is more correct matters a lot for Chinese monetary policy. We tend to be so US-centric when we think about economics – including, unfortunately, most Chinese economists – that we automatically assume that because raising interest rates in the US will reduce consumption and so limit inflation, it must also be the case in China.
Even very prestigious newspapers, citing prominent economists and research analysts, assure us that in order to fight inflation the PBoC raises interest rates. Here for example, is what the Financial Times said three months ago:
China has raised interest rates for the fifth time in eight months, indicating the country’s leaders are still focused on taming politically sensitive inflation, despite evidence that the world’s second-biggest economy is slowing. Benchmark one-year lending rates will be raised 25 basis points to 6.56 per cent from Thursday, while one-year deposit rates will go up 25 basis points to 3.5 per cent, the central bank said on Wednesday.
The rise suggests that inflation is likely to have accelerated to a three-year high of more than 6 per cent in June, well beyond Beijing’s comfort zone. The government is scheduled to announce the inflation figure next week.
Here is Xinhua, on the same day:
The interest-rate hike will help check high inflation and the June CPI data will be 6.2 percent, Lu Zhengwei, chief economist for the Industrial Bank, predicted.
…Guo Tianyong, a professor with the Central China Finance University, said the move is necessary as it can help correct the negative interest rates and manage inflation, but it can also slow economic growth and precipitate inflows of speculative hot money.
A quick Google search uncovers thousands of articles and OpEd pieces that make the same point.
The empirical evidence
But for many years I have strongly disagreed with this claim that raising rates is a way of combating inflation. If it is the wealth effect, and not the consumption-postponement effect, that really drives changes in savings and consumption rates, then raising rates would only reduce consumption if there were a negative correlation between interest rates and wealth, as there clearly is in the US.
Is there a negative correlation between the two in China? Probably not. Most Chinese savings, at least until recently, have been in the form of bank deposits. In a financial system in which deposit rates are set by the central bank, the value of bank deposits is positively, not negatively, correlated with the deposit rate.
Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines. In that case, rising rates should be associated with rising, not declining, consumption and with higher, not lower, inflationary pressure.
I want to repeat this because I think it is a very important source of confusion. In the past few years the consensus on China has dramatically changed, and as a result many of the things I used to discuss which once sounded so strange and “contrarian” (I hate that word) – discussions for example about the unsustainable increase in Chinese debt, the role of financial repression in undermining household income growth, the nature of the Chinese growth model – are now pretty widely held.
But it is still very rare to hear anyone acknowledge that while raising interest rates in China may be a very good thing – because it reduces the capital misallocation on which Chinese growth is highly dependent – it does not reduce inflationary pressure. It increases it.
Needless to say that is why I found the Nabar paper so interesting. My argument had always been a conceptual argument based on balance sheet principles, but Nabar has tested the correlation. He went out and measured changes in consumption as a function of changes in the real deposit rate.
And he finds in fact, in line with my conceptual argument, that higher real rates really are associated with lower savings and higher consumption. Here is what he says:
Although a large body of research has examined the determinants of household saving in China, little attention has been directed to interest rates and their impact on saving decisions. Bank deposits are currently the primary saving vehicle available to Chinese households.
The return households earn on these bank deposits could therefore potentially influence household saving behavior in a tangible way. This research assesses how interest rates affect household saving decisions using a panel dataset that covers China’s 31 provincial-level administrative units over the period 1996–2009.
The main findings are as follows:
- Panel estimates suggest that household savings respond strongly to a change in the real interest rate. A one percentage point increase in the real rate of return on bank deposits lowers the urban household saving rate by 0.6 percentage points.
- A comparison of the relationship across sub-periods shows that the association is stronger in the later period, 2003–09, relative to the earlier period, 1996–2002. The relationship is robust to the inclusion of variables that proxy for other influences on saving such as life cycle considerations and self-insurance against income volatility.
- The evidence also indicates that when the return on alternative investment is high (for example when real property price growth is relatively strong), a decline in the real return on bank deposits does not have as negative an impact on household portfolios.
The results suggest that China’s households save to meet a multiplicity of needs – retirement consumption, purchase of durables, self-insurance against income volatility and health shocks – and act as though they have a target level of saving in mind. An increase in financial rates of return, which raises the return on saving, makes it easier for them to meet their target saving. Financial reform that boosts interest rates could therefore have a strong effect on current tendencies to save.
The consumption share of GDP
I think this is a very important point. For one thing it confirms the claim that financial repression also represses consumption growth, and so is one of the factors at the heart of China’s economic imbalances – in fact I would say it is the main factor.
It also says that monetary policy may have very different consequences from our hidden assumption that it works the same way in China as it works in the US. In the US if the Fed wants to lower inflationary pressures, it raises interest rates to reduce household wealth, to raise the cost of consumer financing, and otherwise to put downward pressure on demand by reducing consumption.
In China however when the PBoC raises the interest rate it has limited effect through the cost of consumer financing (consumer finance is negligible in China) and it actually increases household wealth. This means that raising rates is more likely to encourage inflation than to reduce it.
And since real interest rates have actually declined in the past year, lower real rates help explain why inflation may have already peaked, and why it is coming down. In fact this may be why financially repressed countries can have both rapid monetary expansion and limited inflation, as they typically do. Inflation itself, by lowering real rates, can reduce inflationary pressure. It is self-correcting – at least until households begin withdrawing deposits and spending the money simply because the cost of holding money is too great.
Not surprisingly, as inflation has risen and deposits rates lagged during the past year, much of the evidence suggested that contrary to Beijing’s announced plans, consumption was likely to be declining as a share of GDP. I have said many times that when they finally published the 2010 data in the China Yearbook 2011, I would expect to see consumption drop from 35.0% in 2009 to 34% in 2010 and perhaps another point lower in 2011.
On Friday my associate Chen Long told me the yearbook had in fact just been published, and he sent me the data. Our expectation turns out to have been right. Household consumption for 2010 is reported to be 33.8% of GDP.
Here is the full data:
Aside from the extraordinary decline in the consumption rate, it is interesting to see what happened to the trade surplus. At 6.4% of GDP in 2010, it is extremely high, but well off its record levels in 2007 and 2008, when as a share of global GDP China’s trade surplus may well have been the highest in modern history. Notice that as it declined from its peak, investment surged.
This is just what we would have expected. The negative growth impact of the sharp drop in China’s trade surplus may have forced GDP growth rates to nearly zero, and the sudden and violent expansion in investment was necessary as the counterbalance to keep growth rates high. Changes in the declining consumption share of GDP have had very little impact on changes in GDP growth. And it continues to decline.