Thread: China "worried" about US Treasury holdings

that is the 2 trillion dollars question, isn't it?

Originally Posted by xinhui

Credit Boom

New lending tripled to more than $1 trillion in the first half of 2009 from a year earlier, fueling concern that banks are taking on too much risk and bubbles are inflating in stocks and property. The Shanghai Composite Index has climbed almost 90 percent this year.

This comment is interesting and I have come across it in other places
The PBoC data states that loans to households were around 67 BN RMB (44 BN for consumers, rest for businesses) while loans to non banking corporates were around 330 BN. The corproate loans seem to be evenly split between working capital financing (short term loans, bill financing etc) and long term loans (which would probably be project loans).

So how exactly is this money going into the stock market? Even if I assume that the loans to households are being pumped into stocks and property, that seems to make up onlyb a small portion of the loans being made. I am not naive enough to assume that the none of the money lent to corporates find their way to speculative investments (), but bankers usually keep track of such side business in their portfolio.

Source: http://www.pbc.gov.cn/showacc2.asp?id=2415, pp 6-7

Of course, if the working capital is actually disguised acquisition of commodities for speculation, that's a different matter.

http://www.pbc.gov.cn/showacc2.asp?id=2415

Saw that, but I normally don't post any China based sources here as a way to avoid flames.

antimony, one of the drivers of the recent stock gain is the inflow of foreign cash into the Chinese stock market.



* JULY 28, 2009

Fervor Greets China IPO, Spurs Bubble Talk

Fervor Greets China IPO, Spurs Bubble Talk - WSJ.com

By JAMES T. AREDDY



SHANGHAI -- China's first major new share offering since last year rocketed out of the gates Monday in the latest sign that the nation's efforts to shore up its economy are fueling speculative fervor.

The market's attention will now turn to other IPOs set to hit the market in coming weeks, including the world's biggest so far this year coming Wednesday. Analysts increasingly talk of a possible bubble forming in China's highflying asset markets, including stocks.

Shares of Sichuan Expressway Co. tripled on their first day of trading on the Shanghai Stock Exchange and finished at 10.90 yuan ($1.60), giving the toll-road operator a market capitalization of about $3.4 billion. At one point, its shares were quoted at 15.25 yuan, more than four times the initial-public-offering price of 3.60 yuan.

Trading in Sichuan Expressway was suspended twice during Monday's session after price surges triggered newly implemented circuit breakers on IPOs that are designed to temper investor enthusiasm.

Fundamentals for the road company played little part in the gains, analysts said, and instead investors were placing speculative bets in a market that has already gained 89% this year based on the benchmark Shanghai Composite Index, which added another 1.9% Monday.

"Speculation on newly listed shares is a common practice in a bullish market," said Zhang Ping, an analyst in Nanjing for Huatai Securities Co.

Continued gains in China's stock market illustrate how money has whizzed through the economy even as much of the world remains crimped by recession. While other global markets also are strong this year on hopes of an economic recovery -- the Dow Jones World Index is up 15% in 2009 -- analysts say China's market is driven by slightly different factors.

The surge in stocks mostly reflects how record lending by the nation's banks has supported the economy and left it flush with cash. A recent report that China's foreign-exchange reserves topped $2 trillion sparked fresh predictions of upward pressure on the country's currency and inflows of hot money, factors that would tend to support stock prices.

As lending has grown -- China's banks lent 7.4 trillion yuan during the first half, equal to about half the nation's gross domestic product in that same period -- regulators have stepped up calls for the money to be lent prudently. The China Banking Regulatory Commission on Monday issued rules it said "are designed to ensure bank loans flow effectively into the real economy and boost domestic demand," rather than get funneled elsewhere, like the stock market.

Later this week, shares of home builder China State Construction Engineering Corp. are expected to begin trading in Shanghai in what analysts describe as the world's largest IPO this year. The company already has secured 50.2 billion yuan ($7.35 billion) by issuing the shares.

Everbright Securities Co., an arm of state-controlled China Everbright Group, over the weekend said it received government approval to sell shares. It would be only the second Chinese brokerage firm to launch an IPO.

Agricultural Bank of China Ltd., the last of the country's Big Four state-backed lenders to list shares, said Monday it will start the technical preparations for an initial public offering and hopes it will happen "as soon as possible."
—Bai Lin in Shanghai and Victoria Ruan in Beijing contributed to this article.

Write to James T. Areddy at james.areddy@wsj.com

Originally Posted by xinhui

http://www.pbc.gov.cn/showacc2.asp?id=2415

Saw that, but I normally don't post any China based sources here as a way to avoid flames.

This is Central Bank data, and should be above board. I know that I treat RBI and Fed publications with utmost reverence, don't see why the PBoC shouldn't get the same treatment

Originally Posted by xinhui

antimony, one of the drivers of the recent stock gain is the inflow of foreign cash into the Chinese stock market.

That should be fine and it makes sense, given the recent Forex inflows

But that is different from people borrowing and then pumping that money into the markets. If an FII decides to invest in Chinese stocks and gets burnt in the process, that's their problem. Its much more dangerous (and illegal, in my opinion) if companies or individuals take loans stating one intent (financing working capital, for e.g.) and investing in the market instead.

The blogosphere (not the best source of accurate information) seems to be stating the latter

if companies or individuals take loans stating one intent (financing working capital, for e.g.) and investing in the market instead.

I remember back in the dot bomb days, some radio personalities told listeners to take out a second mortgage and "invest" them in stocks....they argument goes like this -- if your funds can generate 10 to 15% returns and your second mortgage has only has a 8% interest rate, the math seems to work, right?


There will always be people making "questionable decisions" but will those decisions large enough to bring down a market. At this point, with the data available, I don't see that from happening.

Not just the Chinese, the market also "worries".



Treasury Notes Decline as Record Debt Auctions Weigh on Demand
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By Susanne Walker and Daniel Kruger

July 29 (Bloomberg) -- Treasury notes fell after a government auction of a record amount of notes drew higher-than- forecast yields for a second consecutive day, renewing concern a deluge of U.S. debt will overwhelm investor demand.

The $39 billion in five-year notes yielded 2.689 percent, more than 2.635 percent median forecast of eight primary dealers surveyed by Bloomberg News. Investors also demanded higher yields on yesterday’s $42 billion of two-year notes. Interest from an investor class that includes foreign central banks declined at each of the auctions from last month, when those sales attracted the most bids in at least six years.

“You’re starting to see customers pull back from the market,” said Thomas L. di Galoma, head of U.S. rates trading at Guggenheim Capital Markets LLC, a New-York based brokerage for institutional investors. “It’s been a fundamental shift in central bank buying.”

The yield on the existing five-year note rose four basis points, or 0.04 percentage point, to 2.64 percent at 3:41 p.m. in New York, according to BGCantor Market Data. The 2.625 percent security maturing in June 2014 fell 6/32, or $1.88 per $1,000 face amount, to 99 29/32.

Two-year note yields climbed nine basis points to 1.17 percent, while yields on three-year securities increased five basis points to 1.69 percent.

The 10-year note yield fell two basis points to 3.67 percent after earlier rising as much as five basis points. The difference between 2- and 10-year notes fell 0.12 percentage points to 2.49 percent, the lowest level in over two weeks.

‘Point of Saturation’

Indirect bidders bought 36.7 percent of the five-year notes, down from 62.8 percent of the securities at the June sale, the highest since December 2004. This class of investors bought 33 percent of the two-year notes sold yesterday, compared with 68.7 percent previous auction in June. That was the most in at least six years.

The bid-to-cover ratio, which gauges demand by comparing total bids with amount of securities offered, was 1.92. At the June 24 auction, the notes drew a yield of 2.7 percent, the highest since October.

“The total bids are not extraordinary -- what’s extraordinary is the size of the issue,” said William O’Donnell, U.S. government bond strategist at RBS Securities Inc. in Stamford, Connecticut, one of 18 primary dealers required to bid at Treasury auctions. “We’ve just reached the point of saturation in the marketplace, clearly, and it’s just made it very difficult to get these things done.”

Auction Tail

Today’s sale was the third of four auctions totaling $115 billion that is the largest amount of so-called coupon securities sold in a single week. The government is scheduled to sell $28 billion of seven-year notes tomorrow.

The auction’s tail, or amount of yield in excess of where the security was trading before the sale, was 5.4 basis points, or the most on a five-year offering since February 1993, according to data from O’Donnell.

Longer maturity debt benefited as the Fed bought $2.999 billion of Treasuries maturing between February 2021 and February 2026, part of its plan to capping borrowing costs.

“Going outside the back end, given what the curve is doing, is not a good idea,” said Thomas Roth, head of U.S. government bond trading in New York at Dresdner Kleinwort. “Supply is a big thing to handle. The Street is getting socked with a lot of paper.”

The central bank has bought $222.719 billion in U.S. debt since its purchases began on March 25.

Record Borrowing

The U.S. raised $1.02 trillion this year selling Treasury securities to help finance a recovery from the recession, government data show. In its next round of auctions, the U.S. will sell three-, 10- and 30-year securities on three consecutive days beginning Aug. 11.

Goldman Sachs Group Inc. said the U.S. will sell about $2.9 trillion of debt in the two years ending September 2010, cutting its estimate for Treasury auctions by 28 percent, as the economy improves.

President Barack Obama will sell a net $1.9 trillion of debt in the current fiscal year that ends Sept. 30, Goldman said in its report late yesterday. In March it forecast $2.7 trillion. Goldman, also a primary dealer, trimmed its projection for sales the next fiscal year to $1 trillion from $1.35 trillion, wrote Ed McKelvey, senior U.S. economist in New York.

The U.S. federal deficit will be $1.725 trillion for this fiscal year and $1.4 trillion in the following 12 months, McKelvey wrote. In March, Goldman estimated the figures at $1.86 trillion and $1.5 trillion.

Treasuries lost 0.5 percent this month, compared with a 0.3 percent advance for German government bonds, according to Merrill Lynch & Co. indexes.

The financial crisis, which started with the collapse of the U.S. property market in 2007, has triggered $1.52 trillion of writedowns and credit losses at banks and other institutions and sent the global economy into its first recession since World War II. The government and the Fed have spent, lent or committed more than $12 trillion in a bid to revive the economy and credit markets.

To contact the reporters on this story: Susanne Walker in New York at swalker33@bloomberg.net; Daniel Kruger in New York at dkruger1@bloomberg.net
Last Updated: July 29, 2009 15:44 EDT

Treasury Notes Decline as Record Debt Auctions Weigh on Demand - Bloomberg.com

Here is another OpEd from today's WSJ.


China Growth Fueled by Cheap Debt, Not Corporate Profits - WSJ.com

* OPINION ASIA
* JULY 30, 2009, 3:04 P.M. ET

Now China Has a Credit Boom
Companies used to rely on retained earnings. Not anymore.


By PAUL CAVEY

After second-quarter GDP numbers revealed a rebound in China’s growth rate to near the politically significant 8% level, it is easy to think nothing has changed. When the world grows, China grows, and when the world collapses, China still seems to grow. But don’t be fooled: China’s impressive headline GDP rate masks an important fundamental shift. Its growth is now fuelled by cheap debt rather than corporate profits and retained earnings, and this shift in the medium term threatens to undermine China’s economic decoupling from the global slump.

This logic might seem surprising given the conventional wisdom that China’s growth has always been fueled by cheap credit. Interest rates sometimes have been below inflation, making them negative in real terms, which is a common definition of cheap money. More striking still, the official cost of capital has consistently trailed the return. The implication is that companies can re-invest borrowed money for a higher return than they have to pay back to the banks. In this sense, bank credit is more than free.

If this weren’t enough, overseas money has been piling into China, inflating foreign exchange reserves and domestic liquidity. So perhaps it is not surprising that outstanding bank loans have doubled in the last few years, or that there is much talk of a shadow banking system. Then there is China’s reputation for building overcapacity in its industrial sector, a notoriety it won even before the crash in global demand. This showed a disregard for returns that is always a tell-tale sign of cheap money.

But the reality was more complicated. The government kept interest rates low for the past few years to reduce the attractiveness of the yuan in the eyes of foreign investors, in an attempt to discourage speculative inflows. But the government has used huge financial repression to offset this potential monetary inflation, sterilizing inflows and telling the banks not to lend. The supply of money was thus rationed, logically meaning that the real price of money was higher than the rate officially set by the central bank.

As for China’s loan growth, it was accompanied by equally strong growth in the economy. So China didn’t exhibit the usual surge in the credit-to-GDP ratio that is generally associated with monetary bubbles. As for the shadow banking system, it certainly exists. But the formal banking system was restricted by regulation. Informal lending channels were important but seemed to be used most often for short-term cash needs rather than the financing of long-term fixed investment projects.

The net result was that instead of China having an economy swimming in money, the norm was financial repression that prevented the intermediation of undoubtedly excess liquidity into the domestic economy. What about the perception of overcapacity? This showed up in a mix of two phenomena. First, margins would fall, as companies cut prices to boost sales. Second, asset turnover would deteriorate. Measured as the ratio of revenue over assets, this would show sales volumes weren’t high enough to require using all the productive machines that the company had invested in.

On this basis it was possible to find cases of overcapacity in sectors of the economy in recent years, but not that many. Moreover, the industries that seem to have had too much investment tended to be those dominated by state-owned firms. These companies benefited from the limited supply of loans from government-controlled banks because they were able to offer the collateral that China’s banks demanded—land holdings or a government connection that acted like an implicit guarantee.

China’s private sector, by contrast, was short of collateral and thus starved of cash. This pushed them toward labor-intensive industries that didn’t require as much capital investment, which fortuitously were just the ones that were growing most strongly on the back of overconsumption in the United States. The resulting high top-line revenue growth helped offset weak margins, producing a flow of retained earnings that allowed the private sector to finance itself even without access to bank capital.

But that’s all changing now. The slowdown in U.S. consumption amid a credit crunch has exposed the weaknesses in this export-led financing model. So now China is turning instead to cheap debt for funding, a shift suggested by this year’s 35% or so rise in bank loans.

This change is yielding results, with GDP already jumping back towards the magic 8% level. But this isn’t business as usual. While the previous credit rationing implied higher real interest rates, today’s turbo-charged credit figures show the cost of capital is now very low. The longer this persists, the more likely China in the medium term will face just the overcapacity and bad debt that many observers feared already existed.

Policy makers in Beijing are well aware of these risks, having seen so many credit cycles, both at home and abroad. Indeed, fear of end-game problems when a credit bubble inevitably collapses is exactly what made the government so worried about credit growth and asset prices in recent years. Compounding the problem is the lack of any palatable solutions. Strong global growth between 2003 and 2007 provided a safety net, allowing Beijing to tighten domestic credit without worrying that China’s own growth would collapse. This safety net is gone now.

It’s not impossible for Beijing to take away the punch bowl of credit. There is plenty of room to defy the skeptics and in the next few months and push through structural reforms. For instance, some of the privileges state-owned enterprises continue to enjoy in terms of the ability to provide domestic services like banking and telecoms could be dismantled, allowing the country’s more productive private sector to thrive in local markets rather than just overseas. But without such changes China will be relying on growth financed by cheap domestic debt. This means China will be decoupling itself from the U.S. consumer, but at the cost of a credit bubble.

Mr. Cavey is head of China economics at Macquarie Bank.

Originally Posted by xinhui

Look at post number 55 on this thread.

China "worried" about US Treasury holdings



Latest from Krugman of NYT, he is also on the cover of Newsweek. He is still singing the same song about not enough.



Op-Ed Columnist
China’s Dollar Trap

LOL, OpEd folks really need to come up with better titles.

From yesterday's FT.

Beijing’s dollar trap

By Peter Garnham
FT.com / China - Beijing?s dollar trap

Published: July 30 2009 17:19 | Last updated: July 30 2009 19:00

New role for renminbi?China is caught in a dollar trap that has prompted a concerted effort to “internationalise” the renminbi and promote its use outside the country.

Fears over the value of China’s massive dollar holdings, accumulated over the past decade as the country pursued an aggressive policy of export-led growth, have been the trigger for the move.

The market’s focus thus far during the financial crisis has been on China’s call for less dependence on the dollar as a reserve currency and repeated calls for the US to avoid debasing its currency through aggressive monetary and fiscal easing.


But many analysts believe China’s calls for a change to the international monetary regime – earlier this year it suggested using the International Monetary Fund’s special drawing right as a reserve currency – are merely a distraction.

Indeed, China has little incentive to talk down the dollar and such calls are regarded as little more than pleas to the US authorities to keep their finances in check.

Simon Derrick, at Bank of New York Mellon, says China is not in a position to sell a significant portion of its dollar holdings in the open market without causing considerable damage to itself. This means that it must explore a number of different short- and long-term strategies to deal with the problem.

“Developments this year indicate that China now believes that its best long-term strategy is to increase the international role of the renminbi, including its use as a reserve currency,” he says. “This might be the first signal that China is now considering a potential timetable, presumably over years rather than months, for moving towards capital account convertibility.”

It is no wonder the Chinese are concerned about their exposure to the US.

China announced its foreign exchange reserves, the world’s largest, had risen by a record $178.3bn to $2,130bn in the second quarter. Although the exact breakdown of the stockpiles is a secret, analysts estimate that 65-70 per cent are held in dollars.

The largest increase in reserves was in May, when the dollar weakened sharply as Treasury yields in the US rose. Fear of a weaker dollar contributed to inflows to China, sparking offsetting intervention by the Chinese authorities to stem strength in the renminbi.

Clearly more dollar weakness – it hit its lowest level against a basket of six leading currencies this week – is not in China’s interest. Qu Hongbin, chief China economist at HSBC, says this has prompted Chinese policymakers to rethink the root causes of the “dollar trap” they find themselves in.

“There is a growing consensus in Beijing that one of the fundamental reasons the country has fallen into this trap is that its own currency is not yet an international currency,” he says.

This means Chinese exporters and importers have to rely on the dollar for invoicing more than 70 per cent of the country’s $2,600bn annual trade flows.

With China’s exports surging nearly 30 per cent annually from 2002 to 2007, and government controls on overseas investment by domestic corporations and households, most of the dollar receipts can be recycled out of the country though just one channel: the central bank’s reserve accumulation.

“To find an ultimate solution to this issue, apart from gradually loosening controls on capital outflows, Beijing has realised that it is time to push the internationalisation of the renminbi,” says Mr Qu.

Mr Qu says this move is long overdue, given China’s rising economic power relative to the limited use of the renminbi overseas.

China’s nominal gross domestic product topped $4,300bn last year and is estimated to reach $4,700bn this year, implying that China may overtake Japan as the world’s second-largest economy in 2010. HSBC says China was already ranked as the world’s third-largest trading country last year, and is likely to overtake Germany as the world’s second-largest trading nation by the end of this year.

In order to kick-start the process of internationalisation, China has begun an ambitious scheme to raise the role of the renminbi in international trade and finance and reduce reliance on the dollar.

Earlier this month, China announced a pilot initiative that expanded settlement agreements between Hong Kong and five big trading cities, including Guangzhou and Shanghai.

On top of this, to provide seed money to its trading partners, this year the People’s Bank of China has signed a total of Rmb650bn ($95bn) in bilateral currency swap agreements with six central banks: South Korea, Hong Kong, Malaysia, Indonesia, Belarus and Argentina.

HSBC says China is still in talks with other central banks to form additional swap agreements and was likely to expand them to cover all the country’s trade with Asia, excluding Japan.

This would be followed by an expansion to take in other emerging market countries, including those in the Middle East and Latin America, that needed renminbi to pay for their imports of Chinese manufactured goods.

Mr Qu believes the process of internationalising the renminbi may be quicker than many expect, estimating that more than half of China’s total trade flows, primarily bilateral trade with emerging market countries, are likely to be settled in renminbi in the next three to five years.

“This means that nearly $2,000bn worth of cross-border trade flows would be settled in renminbi, making it one of the top three currencies used in global trade,” he says.

But not all analysts believe that China can solve its dollar dependency so quickly.

Indeed, Marc Chandler at Brown Brothers Harriman describes China’s efforts so far in providing currency swap lines as a “drop in a bucket” compared with its trading volumes.

He says China’s dollar dependency is a problem of its own making, given that its reserve accumulation has sometimes been larger than its trade surplus as it sterilises foreign direct investment and speculative inflows into the country.

“I don’t see how use of the renminbi, even if it could be foisted on other countries would solve any of China’s problems,” says Mr Chandler.

He says a more flexible currency will help the Chinese authorities avoid painting themselves deeper into a corner, but it will not change China’s competitive position very much, given the way it really competes is cheap labour costs. I think the talk of international monetary regime change and the renminbi as an invoicing currency is largely political posturing.”

Copyright The Financial Times Limited 2009

Lets look at the index I use from time-to-time, the 10-year bond yield.

US 3.55%
China 3.72%

Mexico with all its problems with drug gangs has a yield of 7.72%.

The Pakistan's government bond stands at 14.16%, wow, that is a good investment.

This week's economist has an article that touches the question about the value of hte yuan.





Rebalancing the world economy: China: The spend is nigh | The Economist


Rebalancing the world economy: China
The spend is nigh

Jul 30th 2009 | HONG KONG
From The Economist print edition
The second article in our series on global rebalancing asks whether China can reduce its trade surplus by consuming more

A REBALANCED global economy requires America to consume less and save more. That means the world’s three big surplus economies—China, Germany and Japan—will have to save less and spend more. None is under more scrutiny than China, whose vast current-account surplus has been fingered by some as the ultimate cause of the financial crisis. The case against China is exaggerated but a surplus of more than $400 billion in 2008, or 10% of GDP, was clearly too big. Can China right its trade imbalances, and if so, how will it achieve rapid growth in future?

The good news is that the surplus is already shrinking. The strong rebound in China’s economy in the second quarter—pushing GDP 7.9% higher than a year ago—came entirely from domestic demand. This sucked in more imports, while exports continued to slump. China’s merchandise trade surplus narrowed to $35 billion in the same quarter, 40% down on a year earlier. Yu Song and Helen Qiao of Goldman Sachs calculate that the decline is even more impressive in real terms (adjusting for changes in export and import prices), with the surplus shrinking to less than one-third of its level a year ago (see chart 1). They even suggest that a monthly trade deficit is possible within the next year.

Another way to look at the huge swing in China’s trade is that net exports (exports minus imports) contributed 2.6 percentage points of the country’s GDP growth in 2007, but shaved almost three points off its growth in the first half of this year.

Most economists think that China’s trade surplus will remain large. The jump in imports in the second quarter included heavy stockpiling of commodities, which will not last; copper imports, for example, were 150% higher than a year ago. Yet the underlying surplus is clearly shrinking. Paul Cavey of Macquarie Securities forecasts that China’s current-account surplus will fall to under 6% of GDP this year and 4% in 2010, down from a peak of 11% in 2007. Exports amounted to 35% of GDP in 2007; this year, reckons Mr Cavey, that ratio will drop to 24.5%.

On the surface, therefore, China is fulfilling the long-standing demand of Western governments that it shift its engine of growth from exports to domestic demand. Thanks to the biggest fiscal stimulus and loosening of credit of any large economy, China’s real domestic demand is likely to grow by at least 10% this year. In fact, the popular perception that China has always relied on export-led growth is rather misleading. Its current-account surplus did soar from 2005 onwards but until then was rather modest. And over the past ten years net exports accounted, on average, for only one-tenth of its growth.

The problem is more that the mix of domestic demand between consumption and investment is unbalanced, and becoming even more so. In 2008 private consumption accounted for only 35% of GDP, down from 49% in 1990 (see chart 2). By contrast, investment had risen from 35% to 44% of GDP. This year the bulk of the government’s stimulus is going into infrastructure, further swelling investment’s share. Chinese capital spending could exceed that in America for the first time, while its consumer spending will be only one-sixth as large. This is China’s most glaring economic imbalance.

Spending lots of money on building railways, roads and power grids is the most effective way for the government to prop up demand in the short term—especially since China, as a poor country, needs better infrastructure. However, the pace of investment is unsustainable. Even before this year’s infrastructure boom capital spending was too great, causing many economists to worry about excess capacity and the risk that bank loans could sour.

China deserves credit for the speed with which it responded to the global downturn. Now it needs to focus on structural reforms not just to keep domestic demand growing strongly and to reduce its trade surplus further, but also to derive more of its growth from consumption and less from investment.

Before exploring how China can do so, it is important first to clear up a misunderstanding. It is often argued that China runs a current-account surplus because its consumer spending has been sluggish. On the contrary, China has the world’s fastest-growing consumer market, increasing by 8% a year in real terms in the past decade. Retail sales have leapt by 17% in real terms in the past 12 months, although this figure may be inflated by government purchases. Even so, China’s consumer spending has grown more slowly than the overall economy. As a result consumption as a share of GDP has fallen and is extremely low by international standards: only 35%, compared with 50-60% in most other Asian economies and 70% in America.

Economists disagree about the main reason why the consumption ratio has fallen—and hence about the best way to lift it. The most popular explanation is that Chinese households have been saving a bigger slice of their income because of an inadequate social safety net. They have squirrelled away more money to cover the future cost of health care, education and pensions. According to Eswar Prasad, an economist at Cornell University, the saving rate of urban households has jumped from 20% to 28% of their disposable income over the past decade. After exploring all the possible causes, he concludes that uncertainty about the private burden of health care and education is indeed the main culprit. The effect has been worsened by an undeveloped financial system, making it hard for households to borrow.
Panos

The Beijing government is acting: it doubled spending on health care, education and social security between 2005 and 2008. But the total amount remains low at only 6% of GDP, compared with an average of around 25% in OECD countries. This year the government has increased pensions coverage and payments to low-income households. It has also pledged to provide basic health care for 90% of the population by 2011, although the new spending appears to be less than 0.5% of GDP each year. If such measures ease households’ worries about future health care, they could encourage them to save less. But it will take years for them to have much effect on consumer behaviour.
Slicing up saving

More to the point, an inadequate welfare state does not fully explain why consumption has fallen as a share of GDP. The first niggle is that most workers lost their state-provided health care and education almost a decade ago, after the reform of state-owned firms, so this cannot really explain why saving has continued to rise more recently. Louis Kuijs, an economist at the World Bank in Beijing, suggests that the extra saving may owe as much to greater income inequality as to the lack of a welfare state. Rich people save a lot more and their numbers have increased.

A second flaw in the thesis is that although urban households have been saving more, rural households have become less thrifty over the past decade. As a result China’s average household-saving rate has risen more modestly. Mr Kuijs calculates that total household saving has risen from 21% of GDP in 1998 to 24% in 2008. Households accounted for only one-fifth of the increase in total domestic saving over the period. Most of the increase in saving came from companies (see chart 3).

This matters for two reasons. First, if anyone saves too much, it is companies, not households. Second, you need to look elsewhere for the cause of China’s falling consumption ratio. The drop in consumer spending as a share of GDP over the past decade has been almost four times larger than the rise in household saving.

The more important reason why consumption has fallen is that the share of national income going to households (as wages and investment income) has fallen, while the share of profits has risen. Workers’ share of the cake has dwindled because China’s rapid growth has generated surprisingly few jobs. Growth has been capital-intensive, focusing on heavy industries such as steel rather than more labour-intensive services. Profits (the return to capital) have outpaced wage income.

Capital-intensive production has been encouraged by low interest rates and by the fact that most state-owned firms do not pay any dividends, allowing them to reinvest all their profits. The government has also favoured manufacturing over services by holding down the exchange rate as well as by suppressing the prices of inputs such as land and energy.

Simply urging households to spend a bigger slice of their income will not be enough to shift China’s growth towards consumption. Beefing up the welfare state is important but policy also needs to focus on how to lift household income and reduce corporate saving, says Mr Kuijs. Making growth more labour-intensive will require lots of difficult reforms. China needs financial-sector liberalisation to lift the cost of capital for state-owned companies and improve access to credit for private ones, especially in services. Higher deposit rates would also boost household income. Distortions in the tax system which favour manufacturing and barriers to private-sector participation in some service industries should be scrapped. State-owned firms ought to be forced to pay bigger dividends. The prices of subsidised industrial inputs should be raised. Land reform and the removal of restrictions on migration from rural to urban areas would also help to lift incomes and thus consumption.

China has barely started on these important reforms. That may be because they involve much harder political decisions than creating a welfare state. They require the government to loosen its control over the economy, something which Beijing will do slowly and reluctantly.

Last but not least, China needs to allow its exchange rate to rise. This would lift consumers’ real purchasing power, discourage excessive investment in manufacturing and help to reduce the trade deficit further. It would also alleviate the risk of a protectionist backlash abroad. From July 2005 (when China abandoned its dollar peg) to February 2009, the yuan rose by 28% in real trade-weighted terms, according to the Bank for International Settlements. But alarmed by the collapse of exports, China has virtually repegged the yuan to the dollar over the past 12 months. As the greenback fell this year, it dragged the yuan down with it. Since February the yuan’s real trade-weighted value has lost 8%.

Economists disagree about the extent to which the yuan is undervalued. In the IMF’s “Article IV” assessment of China, published on July 22nd, officials were split over whether the currency was “substantially undervalued”. Morris Goldstein and Nicholas Lardy, of the Peterson Institute for International Economics, have done some of the most extensive work on China’s exchange rate. In a new study, they estimate that the yuan is undervalued by 15-25%, based on the adjustment needed to eliminate the current-account surplus.

The American government has softened its demands for revaluation, largely because it needs China to keep buying Treasury bonds to fund its own stimulus spending. At the Strategic and Economic Dialogue meeting between American and Chinese officials on July 27th and 28th in Washington, DC, the yuan’s exchange rate was barely discussed. However, the case for appreciation remains strong.

China’s recent efforts to boost domestic spending have helped to maintain robust growth and reduce its trade surplus. But excessive levels of investment are not a recipe for sustained rapid growth. Unless it is prepared to embrace difficult structural reforms and to allow the yuan to climb, China’s commitment to rebalancing will remain half-hearted. In the long run that will be bad news for China itself as well as for the rest of the world.