China’s Great Demand Challenge

by Michael Pettis

Posted January 9, 2009

Global balance of payments has been dominated by the trade and investment relationship between two countries, China and the United States. This relationship is now undergoing a major shift; to the extent that their economic policies do not accommodate this shift, they are likely to fail, in much the same way that economic policy failed in the 1930s. The consequence for the world, and especially for China, could be terrible.

China runs a massive trade surplus with the U.S. and, in recycling this surplus, a correspondingly large capital-account deficit. This recycling has been the main source of the global liquidity that has engulfed the world recently, as well as a constraining factor in the global balance of payments. It is impossible for either country to adjust any part of the balance without a major counterbalancing adjustment from the other, but it is far from clear that policy makers on either side, especially in China, have a clear grasp of the issue. The result is likely to be a steep drop in global growth, much of it borne by China, and possibly even a collapse in global trade.

Other countries have played a role in this imbalance, of course, but with a few important exceptions they have fallen broadly into two camps whose characteristics are typified either by China or the U.S. One set of countries, like the U.S., has had booming domestic consumption and high and rising trade deficits. Their highly sophisticated financial systems intermediated the surge in underlying liquidity into the consumer loans that permitted the consumption binge. The second set of countries, like China, have excessively high savings and domestic investment rates, resulting in a huge and rising surplus of production over consumption, the balance of which is exported abroad.

Until recently, excess U.S. demand and excess Chinese supply were in a temporarily stable balance. As part of running a trade surplus, China necessarily accumulated dollars, which had to be exported to (invested in) the U.S. This capital export did not occur in the form of private investment—indeed it was exacerbated by Chinese net imports of private capital—but rather as forced accumulation of foreign-currency reserves, which were recycled back to the U.S. largely in the form of purchases of U.S. Treasurys and other dollar assets by China’s central bank, the People’s Bank of China. Since China had effectively pegged its currency to the dollar, the PBoC had no choice but to accumulate reserves in this manner.

The recycling process also functioned as a great liquidity generator for the world. In the U.S. the torrent of inward-bound liquidity boosted real-estate and stock-market prices. As they surged, substantially raising the wealth of U.S. households, these became increasingly willing to divert a rising share of their income to consumption. At the same time rising liquidity always forces financial institutions to adjust their balance sheets to accommodate money growth, and the most common way is to increase outstanding loans. With banks eager to lend, and households eager to monetize their assets in order to fund consumption, it was only a question of time before household borrowing ballooned.

Meanwhile in China, as foreign currency poured into the country via its trade surplus, the PBoC had to create local money with which to purchase the inflow. In China most new money creation ends up in banks, and banks primarily fund investment rather than consumer spending. With investment surging, industrial production grew faster than consumption. A country’s trade surplus is the gap between its production and its consumption, and as this gap grew, so did China’s trade surplus, which resulted in even more foreign currency pouring into the country, thus reinforcing the cycle. In this balance, sometimes dubbed Bretton Woods II, Chinese overcapacity was matched with American overconsumption, and Chinese official lending was matched with U.S. household borrowing. This ensured that the current-account flows were matched with the capital-account flows.

The Great Imbalance

Many analysts think of the U.S. economy as the engine that drives the rest of the world, but this is not always true. Sometimes changes or distortions in one part of the world can force adjustments elsewhere, and as the world’s largest and most open economy, with an astonishingly flexible financial system, it is often the U.S. that absorbs imbalances originating elsewhere.

We see this most obviously in U.S. trade figures. For most of last 60 years, with two exceptions, the U.S. current-account surplus or deficit has remained within 1% of GDP. The first exception occurred in the mid-1980s, when the deficit rose to nearly 3.5% of GDP in 1986-87 before declining sharply and running into a small surplus in 1990. The second began in 1994, around the time of the Mexican crisis, when the U.S. current-account deficit climbed to around 1.6% of GDP, declined for two years, and then took off in 1997-98, after which time it raced forward in straight line to peak at around 6% of GDP.

If the U.S. trade deficit were driven simply by a U.S. consumption binge, as is often claimed, it is hard to see why it would have followed a pattern of general stability over many decades marked by two surges–a small one from 1984-88 and a very large one after 1997. If it was driven by changes in Asian savings and trade policies, this pattern becomes easier to understand. The 1980s surge was driven largely by domestic Japanese policies and conditions and is a fascinating case study in itself, but it is the post-1997 surge that is much more interesting and relevant to the current crisis.

Of course, 1997 was the year in which several Asian countries experienced terrifying financial crises and sharp economic contractions. One of the main lessons Asian policy makers learned was that too much dollar debt and not enough dollar reserves put a country at serious risk of a balance-sheet crisis. To protect themselves from a repeat, many Asian governments engineered trade surpluses and began amassing large foreign-currency reserves by managing trade policy and the value of their currencies.

This resulted in what some have called a global capital-flow "paradox." Historically, capital-poor developing countries have been net importers of capital, but in recent years developing countries have been large and growing net exporters of capital to rich countries. For most of the last 50 years official capital exports, in the form of foreign- currency reserve accumulation, were significantly less than net private-capital imports. But in 1998, official capital exports among developing countries began to take off, and by the following year exceeded net private-capital imports. Since then, except for a small decline in 2001, net capital exports from developing countries surged almost in a straight line to around $700 billion annually (combining $1.2 trillion of reserve accumulation versus $0.5 trillion of net private inflows).

But the global balance of payments must balance. As Asian trade surpluses and net capital exports surged, some other part of the world had to equilibrate these adjustments by running large trade deficits and importing capital. The U.S. did exactly this, and the U.S. trade deficit soared after 1997, while at the same time U.S. household savings collapsed.

Now the party is over. The old balance of payments has broken down, and the world is lurching to find a stable new balance. One necessary consequence of the financial crisis must be an increase in U.S. household-savings rates. Collapsing real estate and stock markets have caused household wealth to decline sharply, and households must save more than ever out of current income to replenish their wealth. But even if consumers wanted to continue spending, American commercial banks–caught in one of the worst credit crunches in recent history–are no longer willing to lend for consumption. The U.S. household savings rate has nowhere to go but up.

By how much will U.S. household savings increase? For most of the past 60 years until the early 1990s, household savings rates have varied between 6% and 10% of GDP, except for a brief period during the economic crisis of the 1970s when household savings went as high as 13% of GDP. In the early 1990s, the savings rate began declining slowly, and then virtually collapsed after 1997 when household savings fell to well under 2% of GDP.

Although we can’t say for sure, it is probably safe to argue that U.S. savings rates will climb back at least to earlier average levels, or even temporarily exceed those levels, as American households rebuild their shattered balance sheets. If they return only to 8%, the midpoint of earlier savings rates, this implies that U.S. household savings must rise by some amount equal to 6% of GDP, or, to put it another way, that all other things being equal, household consumption must decline by at least that amount.

Something must happen to equilibrate this decline in U.S. household consumption. Either consumption in other sectors of the U.S. economy–i.e., the government, since businesses are also contracting–must expand by that amount, or consumption by foreign countries, with China bearing the brunt, must expand by that amount (and foreign savings decline). To the extent that neither happens, global overproduction–which consists mainly of Chinese overproduction–must decline by that amount. This is just a way of saying that if net American consumption declines, either consumption must rise somewhere else, or production must fall.

In the best possible world Chinese consumption would rise by exactly the same amount as U.S. consumption drops, and we would quickly reach a new stable balance, with one major difference: The U.S. trade deficit would decline, and the amount of capital exported by China to the U.S. would decline by exactly the same amount (the PBoC would accumulate fewer reserves). But if that doesn’t happen, total global consumption must decline, and the world economy slow–in fact as it slows global income will decline with it, so that both savings and consumption could decline, trapping the world in a downward spiral of unstable adjustment.

However, given that the U.S. economy is about 3.3 times the size of China’s, and consumption accounts for less than 50% of China’s income, Chinese consumption would have to rise by nearly 40% (or roughly 19% of GDP) in order to accommodate an increase in U.S. savings equal to 6% of U.S. GDP. This is clearly unlikely. Of course there is more to the world than simply U.S. household demand and Chinese government demand. There are several other factors that will affect the adjustment. Among the positive ones:

• U.S. fiscal expansion will absorb some of the decline in U.S. household demand.

• The Chinese trade surplus has been equal to about one-half to two-thirds of the U.S. trade deficit, so in principle China should only absorb that share of the global adjustment, while other surplus countries, especially opec via lower commodity prices, absorb the balance.

Among the negative factors:

• Assuming a 6% increase in U.S. household savings, to 8% of GDP, is probably conservative. Goldman Sachs predicts that household savings will rise to 10% of GDP.

• It is not just U.S. households and the government that matter. U.S. businesses affect demand too, and they are likely to contract, thereby increasing the total contraction in U.S. demand.

• The world’s major economies–Europe, and Japan–as well as many of the smaller economies–Latin America, Russia and Eastern Europe–are more likely to exacerbate global demand contraction, with several of them facing capital outflows (and hence a reversal of their trade deficits into surpluses, which adds to global overcapacity).

It’s 1929 Again

Although there are great differences between 1929 and 2008, the global payments imbalances that led up to the current crisis were nonetheless similar in many ways to the imbalances of the 1920s. A few countries, dominated by one very large one, ran massive current-account surpluses and in the process rapidly accumulated reserves. In the 1920s it was the U.S. that played the role that China is playing today. The U.S. economy was plagued in the 1920s with overcapacity caused by substantial increases in U.S. labor productivity. This in turn was a consequence of significant investment in the agricultural and industrial sectors and mass migration from the countryside to the cities.

Although U.S. capacity surged in the 1920s, domestic demand did not rise nearly as quickly. As a consequence, the U.S. ran large annual trade surpluses ranging from 1% to 3% of GDP during the 1920s, or 0.4% of global GDP (China, although only 6% of world GDP, has run trade surpluses of roughly the same magnitude). U.S. overcapacity didn’t matter when there was sufficient foreign demand. It could be exported, mostly to Europe, while foreign bond issues floated by foreign countries in New York permitted deficit countries to finance their net purchases.

But as the U.S. continued investing in and increasing capacity, without increasing domestic demand quickly enough, it was inevitable that something eventually had to adjust. The financial crisis of 1929-31 was part of that adjustment process. When bond markets collapsed as part of the crash, bonds issued by foreign borrowers were among those that fell the most. This, of course, made it impossible for most foreign borrowers to continue raising money, and by effectively cutting off funding for the trade-deficit countries, it eliminated their ability to absorb excess U.S. capacity.

The drop in foreign demand required a countervailing U.S. adjustment. Either the U.S. had to increase domestic consumption, or it had to cut back domestic production, but there was unfortunately more to the crisis than simply the drop in foreign demand. With the collapse of parts of the domestic U.S. banking system, domestic private consumption also fell. The slack in demand should have been taken up by U.S. fiscal expansion, but instead of expanding aggressively, as John Maynard Keynes advised, President Roosevelt expanded cautiously. When the credit crunch came and the world was awash in American-made goods that no one was willing or able to buy, it was unreasonable, as Keynes argued bitterly, to expect the rest of the world to continue purchasing U.S. goods, especially since the financing of their consumption had been interrupted.

Since U.S. production exceeded consumption, the need for demand creation, according to Keynes, most logically resided in the U.S. But Washington had other ideas. In 1927 and 1928 there were already unemployment pressures, and the 1929 collapse in demand exacerbated those pressures. This prompted U.S. senators to respond in 1930 with the notorious Smoot-Hawley Tariff Act aimed at boosting demand for domestic production. They attempted to divert demand for foreign goods to U.S. goods–basically to export their overcapacity–and in so doing force the brunt of the adjustment onto their trading partners. Their trading partners, not surprisingly, retaliated by closing their own borders to trade, causing international trade to decline by nearly 70% in three years, thereby shifting the brunt of the adjustment back onto the U.S.

The trade tariff made things worse not just because impediments to trade are costly to the global economy, but rather because it set off a trade war in which other countries forced the U.S. broadly into balance. In two years, U.S. merchandise exports declined 53%, while the trade surplus declined by 63%. Excess production over consumption had to be resolved largely within the U.S., and since much domestic investment had been aimed at the export sector, the collapse in exports brought a concomitant decline in domestic investment. The U.S. either had to engineer a substantial increase in domestic demand by fiscal means, as Keynes demanded, or adjust via a drop in production and employment. It did the latter.

Today China is facing a similar problem. With the collapse of bank intermediation, U.S. households and businesses are cutting consumption and raising savings. This is a necessary adjustment. Most analysts, perhaps thinking they are echoing Keynes’s analysis of the problem in the 1930s, call on the U.S. government to engage in massive fiscal expansion to replace lost private demand. But this is not what Keynes would have recommended. If declining U.S. private consumption is met with increasing public consumption, the world will simply continue playing the game that has already led into so much trouble. The only difference would be that instead of having one side of the global imbalance accommodated by private over-consumption and rising debt, it would be accommodated by public overconsumption and rising debt. Demand must be created by the trade-surplus countries that have, to date, relied on net exports to protect themselves from their overcapacity. They must force demand up quickly in order to close the gap, and since expecting private consumption to rise quickly enough is unrealistic, it has to be public consumption–a large fiscal deficit.

Might China and smaller Asian countries repeat the U.S. mistake of the 1930s? Perhaps. Beijing already seems to be in the process of defending its ability to export overcapacity. Although there has been an attempt to boost fiscal spending, most analysts argue that this so far has been too feeble to matter much. On the other hand it has tried to protect and strengthen its export sector by lowering export taxes and reducing interest costs, which lower the financing cost for producers and have little impact on consumers.

This cannot work for long. The proper place for new demand to originate is, as in the 1930s, in trade-surplus countries. They should be engaged in expanding demand, not expanding supply. If they try to export their way out of a slowdown, there will almost certainly be another trade backlash, in which case the full force of the adjustment will be borne by the trade-surplus countries, again as in the 1930s—with the proviso that although China’s trade surplus as a share of global GDP is comparable to the U.S. trade surplus in the 1920s, China is a much smaller economy, and so its trade surplus represents a much higher share of its GDP.

In order to make the transition workable and avoid trade friction, the world’s major economies must engineer a joint program of fiscal expansion. The trade-deficit countries should expand moderately so as to slow down the adjustment period and to give maximum traction to fiscal expansion on the part of the trade-surplus countries. China must be given at least three or four years to make concerted efforts to boost domestic demand to the point where global imbalances are more manageable.

The problem is that U.S. (and European) demand contraction is occurring at a shockingly rapid pace. There is a real risk that the adjustment process in China will careen out of control. In order to manage this risk, U.S., European, Japanese and Chinese policy makers must quickly come to a firm understanding of how significant the global adjustment is and how dangerous the process will be for China, and design a multiyear plan of demand expansion in which China is given time to adjust its overcapacity. If major economies focus only on domestic adjustment, China will almost certainly choose the path of defending its ability to export overcapacity onto the rest of the world, while the trade -deficit countries will discover the expansionary impact of trade constraints. In that case it is hard to imagine how China and the world can avoid disaster.

Michael Pettis is a finance professor at Peking University and the author of The Volatility Machine (Oxford University Press, 2001).