Looks like someone’s catching on to the interest rate channel. And Bloomberg is reporting it.

(Bloomberg never reported it when I communicated with them.)

China Seen Robbing Consumers With Low Interest Rates

Aug 6 (Bloomberg) — Peking University professor Michael
Pettis was discussing declining bank-deposit returns when a
student interrupted with a story about her aunt that may stymie
China’s plan to boost consumer spending.

“To send her son to university in six years it means she
must replace each yuan in lost income with one from her wages,”
the student said, according to Pettis.

The government’s policy of keeping interest rates low to
reduce the burden of soaring municipal debt is costing savers as
much as 1.6 trillion yuan ($236 billion) a year in lost income
on bank deposits, according to Pettis, former head of emerging
markets at Bear Stearns Cos. To make up the shortfall, savers
have to set aside a larger proportion of wages, undermining
China’s efforts to counter slower export growth with consumer
spending at home.

“Consumption is already at a dangerously low level,” said
Pettis, author of the “The Volatility Machine,” a 2001 book
that examines financial crises in emerging markets. “If it
doesn’t begin to rise very quickly, China has a problem because
household consumption will continue to drop as a share of GDP.”

Emphasis on exports and investments have caused domestic
consumption to fall to 35 percent of gross domestic product, the
lowest of any major economy, from 45 percent a decade ago,
Societe Generale AG says.

Pettis isn’t alone in being skeptical about a consumer boom
in China. Yale University finance professor Chen Zhiwu and Huang
Yasheng at the Massachusetts Institute of Technology also
predict constrained consumer spending.

State Controlled

Chen estimates the state controls 70 percent of the
nation’s assets and says most of its profits don’t flow to
consumers. On an inflation-adjusted basis government income
surged more than tenfold in the past 15 years while disposable
urban income increased less than three times, he said.

Pettis said the drag on consumer spending from depressed
deposit rates may help slash China’s annual economic expansion
to between 5 and 7 percent a year through 2020, from an average
of about 10 percent in the past decade.

The Group of 20 nations has urged China to boost domestic
consumer spending to help offset reduced consumption from debt-
strapped consumers in the U.S. and Europe. If Chinese shoppers
fail to take over that mantle as the government’s 4 trillion
yuan in stimulus wanes, then the nation may have to fall back on
exports for growth. That would revive trade disputes with the
U.S., which is battling 9.5 percent unemployment, said Huang.

Trade Tensions

“I do not see how trade tensions can be avoided,” said
Huang, a professor at MIT’s Sloan School of Management in
Cambridge, Massachusetts, and author of “Capitalism with
Chinese Characteristics: Entrepreneurship and the State.”
“Even in the best-case scenario I do not see household
consumption replacing investment as a driver of growth in the
foreseeable future.”

China’s leaders have vowed to boost consumption’s share of
GDP since at least 2006 — so far to no avail. The ratio of
consumption in China’s economy is about half that of the U.S.,
and about 60 percent of both Europe and Japan, according to
Credit Agricole CIB.

China’s past development has created an “irrational
economic structure” and “uncoordinated and unsustainable
development is increasingly apparent,” said Vice Premier Li
Keqiang in a June article in the government-owned Qiu Shi
magazine. Long-term dependence on investment and exports for
growth “will grow the instability of the economy,” he said.

Low Rates

Pettis computes the 1.6 trillion yuan in lost returns to
savers by comparing the difference between China’s nominal
deposit and growth rates to those in other emerging markets.
That calculation indicates China’s deposit rates should be at
least 4 percentage points higher, he said.

“The government maintains a cap on deposit rates, which
helps prop up bank profits, but only by spreading the cost to
households in the form of artificially low interest returns,”
said Mark Williams, an economist at Capital Economics Ltd. in
London who worked at the U.K. Treasury as an adviser on China
from 2005 to 2007.

China has left interest rates unchanged since December 2008,
even as countries from Malaysia to Taiwan, South Korea and India
raised them. The central bank sees little need for an imminent
increase, the International Monetary Fund said in a staff report
on July 29 after consultation with the Chinese government.

China’s inflation, near a two-year high of 2.9 percent in
June, is also eroding household savings. That may cause people
to spend less and save more to cover rising costs of healthcare,
pensions and children’s education, said Pettis. The one-year
deposit rate is 2.25 percent.

Lost Returns

In June 2009 savers earned a real return on one-year
deposits of 3.95 percent. That slumped to a negative 0.65
percent in June this year, indicating lost returns to savers of
1.8 trillion yuan annually compared with a year earlier. Pettis
estimates China’s household deposits account for 60 percent of
total deposits, or about 40 trillion yuan.

Chinese investors have few appealing options. Capital
controls inhibit citizens from investing overseas. A crackdown
on property speculation may cause property prices to fall as
much as 30 percent in the next 12 months, according to Barclays
Capital. The Shanghai Composite Index, up 0.1 percent as of the
11:30 a.m. local time break in trading, has slumped about 20
percent this year.

Pettis said the 3.06 percentage-point spread between
deposit and lending rates that is set by the central bank will
help banks pay for potential bad loans after an 18-month lending
boom that was almost as big as the U.K.’s gross domestic product.

Bad Loans

“Evidence is mounting that the lending spree not only has
created bad loans but is now constraining monetary policy,”
said Huang.

Concern about potential losses in the financial system may
deepen after China’s banking regulator decided to conduct stress
tests of the nation’s lenders. The tests include a worst-case
scenario of property prices falling as much as 60 percent in
cities where they have risen significantly, a person with
knowledge of the matter said.

Banks could be saddled with bad loans of more than $400
billion, said Jim Walker, chief economist at Hong Kong-based
Asianomics Ltd.

Some economists argue that surging retail-sales figures and
rising wages show China’s shift to greater consumer spending is
on track. Dariusz Kowalczyk at Credit Agricole CIB in Hong Kong
estimates consumption will account for 47 percent of GDP within
10 years.

Retail sales rose 18 percent in the first half of 2010 to
7.3 trillion yuan. Citigroup Inc. says wages in the unskilled
labor market may double over the next five years.

Middle Class

“Disposable income levels are growing, the middle class is
growing and urbanization is alive and strong,” said Andy Mantel,
Hong Kong-based managing director of Pacific Sun Investment
Management Ltd.’s consumer-focused Mantou Fund, which invests
mainly in Greater China equities. “That would be positive for
the next five to 10 years.”

Mantou’s holdings include companies like Fujian-based fruit
and vegetable producer China Green (Holdings) Ltd. whose new
drinks line is “higher quality than has been available on the
market,” said Mantel. “People these days are willing to pay a
bit extra for better products.”

Hong Kong-based Nomura Holdings Inc. analyst Emma Liu
expects China Green’s stock to rise more than 20 percent over
the next year to HK$10.8 ($1.4).

Investor’s Picks

Rising rural incomes prompted Shanghai-based River Fund
Management to buy shares this year in Qingdao-based Qingdao
Haier Co. Ltd. and Zhuhai-based Gree Electric Appliances Inc.,
two of China’s biggest makers of air conditioners.

“People nowadays are not only replacing their old air-
conditioners, but upgrading from low-end to high-end ones,”
said fund manager Zhang Ling. “This will continue over the next
10 years.”

Driven by government subsidies for consumer products
including cars and refrigerators, retail sales rose 16 percent
in 2009 after adjusting for consumer price changes, the most
since 1986.

China supplanted the U.S. as the world’s largest auto
market last year as vehicle sales jumped 46 percent. Households
borrowed 2.5 trillion yuan, almost four times more than a year

Even as sales rise, the hope that China was at “a turning
point” for the role of consumer spending in the economy may
have been premature, said Nicholas Lardy, a senior fellow at the
Peterson Institute for International Economics in Washington.

‘More Unbalanced’

The economy is “still becoming slightly more unbalanced”
toward investment, said Glenn Maguire, chief Asia Pacific
economist at Societe Generale in Hong Kong. “Until consumption
grows faster than fixed-asset investment for a sustained period,
the economy will remain unbalanced.”

Urban fixed-asset investment surged 25.5 percent in the
first half to 9.8 trillion yuan. Another 29.6 trillion yuan is
needed to finish outstanding fixed-asset projects, said Sun
Mingchun, an economist with Nomura Holdings Inc. in Hong Kong.

To achieve sustained rebalancing, China should allow a
stronger currency that boosts household purchasing power,
improve pension and healthcare coverage and gradually allow
markets to determine interest rates, the IMF report said.

“I never believed the hype that China was turning the
corner on rebalancing growth toward consumption,” said Huang.
“The main political agenda is not to let GDP growth slip and
that means continued investment growth.”

6 Responses

  1. Pettis’ argument seems more complicated than yours. He argues that the effect of interest rates on the wealth effect is actually opposite in China to that in the US. In China, lower interest rates mean lower interest income accruals and lower accumulated wealth. In the US, the same deflationary income dynamic is at work, but he argues that this income effect is dominated by the effect of the same interest rate change on the discount rate for asset values. In the overall wealth effect, higher asset values dominate lower interest income accruals in the US. Not so in China.

    From a pure accounting perspective, one might say that China’s wealth effect is more accrual oriented (also consistent with the way in which China thinks about risk on its foreign exchange reserves, I suspect), while the US wealth effect is more marked to market oriented. I would say that now the US has experienced such a catastrophic marked to market meltdown (stocks and houses), saving behaviour will turn long cyclically to a more accrual oriented mentality (e.g. dividend stocks and actually saving money from income, as per MMT explanations).

    From Pettis:

    “This should suggest that some of us, and I would argue perhaps nearly all of us, don’t really think of the interest rate as what we get paid to postpone consumption. We are more apt to think of savings in a different way.

    We want to have a certain amount of wealth to pay for expected expenses, retirement, holidays, emergencies, or whatever, and we save in order to achieve that target. In that case we save to manage a targeted increase in our wealth, and unexpected changes in our wealth will affect our savings rate. This is called the wealth effect, and I suspect the wealth effect, more than anything else, drives savings. In the US, for example, US consumption as a share of GDP tends to be correlated with the performance of stock, bond and real estate markets. Most Americans have a significant part of their savings in the form of stocks, bonds, and real estate, and when these markets rise, Americans feel richer and spend more out of their monthly income. Their savings rate declines and their consumption rises.

    What does all this have to do with interest rates? Typically when interest rates decline, asset markets rise. This makes Americans feel richer, and so they increase their consumption, even if their wage and salaries don’t rise. This I suspect is why in the US and many other rich economies we associate declining interest rates with a decline in savings.

    But not in China. The financial system and the way people save in China, and many other developing countries, especially in Asia, are very different. First, deposit rates in China are not set by the market. They are set by the PBoC to achieve specific policy objectives – for example to determine the profitability of the banking system, in the way explained by last week’s post.

    So when the PBoC announces a change in the deposit rate, it reflects current policy decisions, and not a change in underlying interest rates that affect the value of assets. Second and more importantly, most Chinese have the bulk of their financial wealth in the form of savings deposits, not in the form of stocks, bonds and real estate. By the way those that do have lots of other assets tend to be much richer, so changes in their wealth have less effect on their consumption behavior.

    The general wealth effect in China, then, is mostly about the impact of interest rate changes on the perceived value of bank deposits, and not on stock and real estate markets, and I would argue that consequently the impact of interest rates on the wealth effect is the opposite in China as in the US. In other words rather than lower interest rates being associated with increased wealth, as in the US, it is associated with reduced wealth.

    Why? Because we all have an implicit rate at which we discount money, say our inflation expectation, and this has an important side effect when we think about our wealth. My sense of my wealth is partly affected by the amount of money I currently have in the bank, but also by the rate at which I discount the earnings on those deposits over the period in which I have targeted the amount of total savings I want to have. If the deposit rate rises with no change in my implicit discount rate, I immediately feel richer, and if it declines, I immediately feel poorer. If I have a lot of savings in the bank, my total income is very positively influenced by the deposit rate.
    In that case the wealth effect works very differently in China than in the US and many other developed countries. Declining interest rates in the US usually (but not always) mean that Americans feel richer because the market value of their homes, stocks and bonds has risen. Declining deposit rates in China usually mean that Chinese feel poorer because the return on their savings relative to their implicit discount rate has declined.

    This is probably why interest rates seem to have the opposite effect on consumption in the two countries. In China if interest rates (or, more accurately, deposit rates) rise, it increases the wealth of Chinese households by shifting wealth from the banks and users of capital to households. In effect rising deposit rates increase household income significantly, and so increases household consumption.”


      1. The argument is that the effect of interest rates is not the same in China as the US. The Chinese are in the traditional saving > return > wealth model, whereas it is argued that the US has converted to the wealth effect > debt > consumption model, and that this is the model that the administration is basing its economic policy on.

  2. As an aside, presumably the reason the Chinese government is allowing labour militancy, especially with foreign employers, is to raise wages and thereby consumption. Higher wages will far outweigh the effect of low interest rates. If people save too much despite that, the country will need unemployment insurance and pensions to offset fear of the future.

  3. Bad loans etc: looks like the Chinese are distorting economic policy to help banks just as in Europe and the U.S. They’ve fallen for moral hazard. Those Communist (ho, ho) leaders have the same distain for ordinary Chinese as the U.S. elite has for Main Street. Crony capitalism rules.

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