Too much risk tolerated by the authorities, mistakes in the financial policy of the Federal Reserve and the politization of the real estate market have become easier by the policy of China, which invests current account surplus mainly, though not exclusively, in the bonds of the US government. While foreign countries notice a chance of safe investment in the USA, mainly in the bonds of the American government, the US residents look for high profit abroad. The USA can be described as the manager of savings of China and the rest of the world.
Let us start with the basics of economy and common sense. Inclination to saving up in each culture to a certain extent depends on the income and wealth. The amount of income and wealth corresponds to the amount of savings. Inclination to saving up in poor countries was considered a virtue due to the need of investing (and, until the 1820s, all the countries were poor compared to nowadays). It was particularly respected in Calvinism and quasi-religion Confucianism. The fundamental law of psychology by J.M. Keynes and W. Rostow presents the rising inclination to saving up as a function of per capita income. The history of economy proves that savings of an average English (European?) did not exceed 5-10% of their income before the Industrial Revolution, in the 18th century. With economic development and affluence, the savings rate reached about 20% of the GDP. However, it rarely exceeded 25% of the GDP.
On the other hand, relatively poor countries, with less inclination to save up, should be a magnet for capital from other, richer countries. Return on the invested capital or profitability of investments should be higher in these countries than in countries that are abundant in capital. The latter ones have exhausted their chance of lucrative investments to a large extent. This observation is consistent with the common law of economy about decreasing effectiveness of production factors. Extra 100 dollars invested e.g. in the USA could bring less profit than the same 100 dollars invested in Kazakhstan or China. In other words, capital should flow from the developed countries to developing ones, ceteris paribus.
Indeed, economic practices were concordant with the theory of economics during the first phase of globalization, that is from the 2nd half of the 19th century till the outbreak of the First World War. British capital at that point flooded the world. In 1913, current account surplus in Great Britain amounted to 9% of the GDP. In other words, export and income from transfers, dividends and interest from capital that was invested abroad significantly exceeded import and transferred income from capital invested in Great Britain. As much as 2/3 of English capital was invested outside the British Isles during the period between 1865 and 1914. England suffered from so called home bias only to a little extent. It could be translated as a “preference for the mother country”. British savings surplus was invested abroad. 48% of recorded bonds in London were foreign bonds. It meant that almost half of private investments performed by the English were invested outside the British Isles, while e.g. Nigerian and other colonial countries’ bonds were not secured against the risk of insolvency. The unknown was only how long the British Empire would last.
In fact, little has changed since those days. Some relatively poor developing or “emerging” countries, especially China, are more inclined to save up than many developed and rich countries of the West. What is more, export savings surplus is exported to richer countries, mainly to the USA. People’s Republic of China denied the fundamental law of psychology by Keynes and Rostow, according to which rising inclination to save up is a function of income per capita.
Chart 1: Gross national savings rate (S), gross investments (I), current account balance (CAB) and state budget balance (BudBal) in China and the USA in 2008 and 2009 (% of the GDP)
Source: IMF Executive Board Concludes 2009 Article IV Consultation with the People’s Republic of China; IMF Executive Board Concludes 2009 Article IV Consultation with the United States of America.
The above chart shows huge differences between gross national savings rate (S), gross state investments (I), current account balances (CAB) and budget balances (BudBal) between the PRC and the USA. What is interesting, while the relation of investment shares in the GDP between China and the USA is of 3:1, the relation of gross savings shares in the GDP is of about 5:1. It comes from the fact that savings of the Chinese that are not invested in their economics are exported to other countries, mainly developed ones, like the USA. Big difference in the current account balance between these countries proves this. Worth noticing are also high deficits of the public sector in the USA in the years of the world financial and economic crisis (nota bene caused by a low level of separation between the American financial system and the current internal policy). Even bigger differences between China and the USA took place in terms of inclination to save up in households. Since 2000, Chinese households saved up about 25% of disposable income, while American households (according to OECD) 1,7% (and 0,4% in 2005). Keynes as well as Marshall and other classics would look at the above chart in disbelief, because they would not accept the fact that the poor may finance the rich.
Let us think about factors that could be responsible for such inclination to save up and export of capital [demonstrated by high (almost 10% of the GDP) current account surplus of the foreign trade] among the Chinese. After all, the trade direction is from relatively poor countries to richer ones. The Chinese economic successes are commonly known and often spectacular (as extremely high and continuous rate of economic growth at the level of 9% a year between 1978 and 2005 and as much as 11,7% p.a. in the three pre-crisis years 2005-2007 – IMF data). However, Chinese economy shows many weaknesses that are rarely exposed. The relative weaknesses of their economy derive from two main maladies:
- Common uncertainty of the Chinese resulting from:
- historical burdens of the Mao epoch (and earlier),
- certain aspects of demographic and social policy after the death of Mao:
- financial implications of the “one child” policy,
- minimal range of social insurances,
- underdeveloped law and order system,
- relative uncertainty of private ownership rights,
- still significant politization of life of the PRC residents.
- Still relatively low efficiency of production factors – physical and human capital:
- backwardness of financial system,
- domination of the extensive model of economic growth,
- high level of resource wasting and corruption.
Social and economic, sometimes catastrophic, experiments of 30-year epoch of Mao Tse Tung overshadow its few successes (e.g. increase of literacy, new railways or decentralization of decision-making). These experiments left high dose of uncertainty in everyday life, which still exists in the older generation. Of course, this uncertainty must lead to attempts of securing oneself against the potential arbitrariness of the authorities. Increased inclination to saving up in households is one of the methods to fight this uncertainty.
Let us remind some known acts of the Mao regime:
- 1952: the first “patriotic” campaign of denunciation: 3 mln victims;
- 1957: arrest of 30 000 Chinese who, encouraged to be honest, expressed their views and fears during the so called campaign of 1000 flowers;
- 1958: people’s communes based on shared farming and the economic experiment of the Great Leap Forward: 150 mln of the Chinese search for iron ore and produce iron by means of outwork – they meet imposed requirements, e.g. by melting tools, etc.;
- 1959-61: hunger and death of 30 mln people;
- 1966: famous cultural revolution that turned the Chinese tradition upside down: the second “cultural” campaign of denunciation;
- 1966-78: closing down of vocational schools, restrictions in foreign trade, almost complete lack of access to the world’s technology; as a result, the GDP per capita in 1978 did not exceed 210 dollars.
Popularization of social insurances for the workers of state-owned companies belongs to rather controversial benefits in the Mao epoch. In socialist countries, state-owned companies enjoyed soft budget restrictions hence avoiding financial responsibility. The so called rate of income replacement with social allowances amounted to 75-80%. By the end of the Mao epoch, the gross national savings rate was rather moderate – about 20% of the GDP. According to the old Chinese principle of “saving the face”, Mao Tse Tung is still considered one of the great leaders of the nation, who was 70 percent right despite several mistakes”.
Implications of the demographic policy by Deng Tsiao Ping and his successors
Since 1978, China introduced radical changes in the demographic policy, introducing the one child policy. The one child policy and deeply rooted Confucian ideology of respect and care towards parents certainly contributed to the increased inclination to saving up in households.
Extra increase in the savings rate became one of the unpredictable side effects of the “only child policy”. Deeply rooted preference for male descendants (due to the high cost of dowry for females) caused evident “losses” in female babies. This resulted in the excess of young men compared to the number of women ready to marry. The Chinese who wanted to enter into marriage multiplied their property by way of immoderate saving, e.g. to buy a flat. However, it could not contribute to a significant Chinese savings increase. It is estimated that about half of the increase in the household savings rate in the years 1990-2007 can be ascribed to the new demographic policy of China.
Changes in the social policy after 1978 are not brought into people’s awareness. This is probably the basic reason for the extremely high savings rate in China (almost 59% of the GDP in 2008). China introduced (contra)revolutionary changes in social welfare system after Mao Tse Tung had left. They concentrated on the state infrastructure development at the expense social transfers. Currently, only about 45-55% of city dwellers and only about 10-20% of country dwellers (according to: Nicholas Lard, Policy brief, October 2006) have the right to free welfare services. Moreover, mere 3% of workers who migrate from the country to the cities in search of work have these rights. Unemployment insurance refers to about 14% of the workforce. Well-developed system of internal passports serves as an effective instrument of the PRC citizens classification according to rights they possess. It is estimated that expenditure on social welfare constituted only 3,5% of the China GDP in 2005.
Social welfare system
Since the death of Mao Tse Tung, the healthcare sector noted radical withdrawal of state subventions. In 1977, health insurance embraced 90% of both city and country dwellers. Private expenses for treatments amounted to about 20% of total medical expenditure. 30 years later, social system of healthcare embraced about 50% of city dwellers and only 12% of country dwellers and private expenses for healthcare reached about 55% of total expenditure in the sector.
The World Health Organization (WHO) has recently ranked China on the 144. place in the world in terms of the range and effectiveness of public healthcare and on the 188. place in terms of objectivity and fairness of healthcare system. Any Chinese who has a sense of self-respect and is outside the range of social insurances keeps a significant part of their income “for a rainy day”.
With an ageing society, the main sector of public insurances is the sector of public pension benefits. According to general social insurance proportions, pension entitlements refer to only 45% of city dwellers and 12% of country dwellers. The average for the whole China is 17% to 25% of the population, according to estimations.
In the years 1991-97, the urban pension system was based on two pillars:
- Pillar I offers low (20%) local income replacement rate (!), 17% financed by the employer and provided after mere 15 years of work for the state.
- Pillar II financed with individual bills which obtain 3% from the employer and 8% from the employed. They offer 38,5% replacement rate. The benefits are accessible to those who worked for 35 years.
This system is able to provide benefits for only 11 years of the pensionable age (i.e. from the 60. year for men, according to law). However, having entered the pensionable age, an average Chinese lives 20 years in the case of men and 27 in the case of women. What is now and especially what is to come in terms of demography reduces the effectiveness and solvency of the Chinese pension system. One of the reasons is the one child policy. The current ratio of working people to pensioners is 3:1, and it is going to be 1:1 in 2035. It is estimated that all citizens of China will be entitled to pension rights at the earliest about 2155, that is in 150 years’ time, given the current pace of state pension insurance extension. Of course, it will significantly affect estimations about the savings rate in Chinese households in future.
Education has enjoyed great respect in the Chinese society for a long time. What is more, it has gained the often deserved reputation for impartiality. It is worth mentioning that studying in Chinese schools is different from the German ones, where children end lessons at 1 p.m. Chinese students spend at school 14 hours, from 7.40 a.m. till 10 p.m.! Education de facto is paid to a large extent despite an opposite regulation in the Chinese constitution. Expenses on state education at all levels make up mere 2% of the GDP. As a result, parents pay even for primary education for their children.
No independence and rule of law tradition, limited private property rights
The so called third power, the judiciary, has been executive-independent neither in the tradition of Imperial China nor now. It is weak and extremely politicized. Lawfulness does not stand firm in the political system of China. More important is the position occupied by a person or a company in the formal or informal hierarchy as well as relations and contacts they possess (quanxi). In 2002, the World Bank ranked China on the 94. place in terms of “lawfulness” among 199 classified countries.
Private property rights are subject to similar, though changing, factors. Having suffered confiscations, communes and the communism of Mao Tse Tung, the Chinese obtained limited rights of land, flat and capital lease rather than ownership. They have the right to flat lease for 70 years and land lease for 30 years, which is then automatically prolonged. It is worth mentioning that, according to Lee John, lack of full land property rights is a feature of a docile society.
Rights in terms of capital are limited in the PRC. In 2003, only 13,3% out of 180 000 companies with 0,6 mln dollars turnover had (according to OECD) the undisputed status of private enterprises. Only 40 out of 1500 companies (2,7%) registered at the Shanghai stock market had the status of a private entity. The Chinese state has the majority of shares in most major companies registered at this stock market (31 out of 35). The state owns about half of the registered companies, but it probably controls about 80%. In concordance with tradition, party cells (the CPC) are present in every major company.
China does not possess developed anti-monopoly law. State-owned companies enjoy privileged access to capital and credits. They obtain about 70% of China’s capital, though they produce only 30% of national income. It is notable that these proportions are almost exactly opposite to Taiwan. It is estimated that only a small proportion (2,5%) of short-term credit is given to private domestic companies. According to the theory of economy and tradition, production factors’ effectiveness in major state-owned or state-controlled companies is low. It amounts to about half of effectiveness in private companies. Property confidence index published by the Heritage Foundation is 20 points for China (same as Bangladesh and Uzbekistan), but for Taiwan and South Korea – 70 points. The difference is substantial. The high savings rate is of course essential to maintain the high pace of production increase in state-owned companies that have relatively low factors’ effectiveness. Consequently, high capital investments can be financed to compensate low factors’ effectiveness.
From the legal point of view, Chinese economy does not consist of two sectors (state and private sector), but rather three: state, domestic private capital and foreign capital sector. Chinese law treats domestic and foreign capitalists differently. Foreign capital is privileged compared to domestic. For example, the PRC citizens can possess only 20% of Chinese bank’s shares, while foreign residents can possess 25%. Joint ventures are particularly popular and enjoy privileges in the Chinese legislative and economic system.
Financial system’s backwardness
Low effectiveness and profitability of the banking system, which is dependent on the state (or the CPC), and the high amount (about 40% of the GDP) of non-performing credits also influence the low effectiveness of the economic system. It is estimated that 2/3 of these credits are not based on economic criteria.
The public sector has limited access to investing in banking. Banking and the judiciary alike are politicized to a large extent. Problems of the Chinese financial system are well-known:
- no strong and independent central bank;
- banks have limited chances to borrow on security due to the imperfect system of private property rights;
- limited selection of saving forms and financial assets (products)
- only 11% of the young Chinese take mortgage loans;
- low and controlled interest rates (1,8% for a three-month credit) make it necessary to ration the credit – often according to political needs;
- no independent bank audit
- in 2002, the World Bank ranked the Chinese system of financial responsibility on the 186. place among 199 assessed countries.
As a result, the high private savings rate compensates to a large extent the negative effects of the low effectiveness of the Chinese banking system.
Significant insufficiency in the PRC economy demonstrates the need of high savings.
Many sectors dominated by state-owned companies, which remain under the strict supervision of the state and the CPC, are not subject to market competition. Capital consumption, and in particular – energy consumption, is too high in many sectors, despite overpopulation in the Chinese country. It is estimated that energy consumption (based mainly on coal) per product unit is 4 times higher than in the USA and 8 times higher than in Japan. In 2008, China consumed 2760 million tons of coal (Poland – 83 million tons). According to some sources, capital consumption of the investment process worsened compared to the epoch of Mao Tse Tung. It revolves around the ratio of 5 yuans of investment to 1 yuan of product.
The relatively ineffective process of investing must be compensated by the high savings rate. It seems that this process has even strengthened. The investment rate increased from 40% of the GDP to 49% of the GDP in 2008 despite the fact the CPC and Chinese politicians have supported (at least since 2004) the capital-intensive nature of production and the fast development of sectors that produce consumption goods. According to the World Bank’s study, the rate of return is negative in 1/3 of investments.
Extensive, capital- and energy-intensive super-growth of Chinese economy is supported by the policy of yuan depreciation and enormous payment surplus abroad. The real exchange rate of yuan depreciates and helps to find large trade surplus and use large labour resources (particularly in the country). China works out large current account balance surplus [i.e. export and import surplus from interest rates of foreign assets (mainly the US bonds) and dividends over the import and export of interest rates as well as dividends for the foreign capital and netto transfers] – which amounts to 364 billion dollars a year in 2009, i.e. 6,1% of the GDP. Such a policy results in a spectacular export increase. Export share in the China’s GDP rose from 3% to 40% between 1979 and 2007, and the average export increase rate between 1980 and 2007 reached the staggering pace of over 30%. During six years (1999-2004), China moved up from the 9. to the 3. place in the world in the scale of export. Real depreciation of yuan lifts the relative internal price of “trade goods” (i.e. goods subject to foreign trade) at the expense of the relative price of “non-trade” goods and services and also disciplines the economy. It moves the means of production to trade sectors and increases the economic growth rate. On the other hand, China lifts the price of the US government’s bonds by investing in them, and consequently contributes to the interest rate reduction in the USA. Thus, China is indirectly responsible for overinvesting in the US mortgage loans (low real interest rates reduced the investment risk a few years after the terrorist attempt, thus China is indirectly co-responsible for the world financial and economic crisis 2008-2009).
The degree of economy politization, production factors’ effectiveness and the savings rate
The China’s record savings rate is almost 3/5 of the GDP. It comes from the high degree of legal, social and political confidence, backwardness of private land and capital property rights, excessive state property (following the CPC military operation on the Tiananmen Square, a significant decrease in the private sector investments took place, especially in the Chinese country) and state control of economy on the one hand and extensive phase of economic growth that is relatively ineffective in terms of production factors, on the other. Record-breaking on the global scale savings rate reduces the negative effects of weak roots of the major capitalism institutions and the CPC arbitrariness. A weakness turns into an advantage in this way.
Another glance at the Chart 1 shows large differences in savings and investment rates between the USA and the PRC. The difference between the investment rates in these countries was about 32 per cent, according to recent data. The difference in the savings rate amounted to 46 per cent, i.e. almost half of the GDP. The savings rate in China is almost 10 per cent higher than the investment rate. Notable is the fact that the situation is opposite in the USA, where the investment rate is about 3-4 per cent higher than the savings rate. Of course, the opinion of the known economist Feldstein Martin: “low national savings are the fundamental reason for the trade deficit in the USA” is not true.
As it has been mentioned in the introduction, capital should theoretically be sent to countries where it brings more profit. It seems that a relatively poor country, like China, is definitely less saturated with capital than the USA and therefore capital should be sent there. Combined with cheap labour, it should bring high profit. In other words, the current account balance in China ought to be negative, while in the USA – positive. Reality is the opposite. It is possible to explain the paradox of apparent irrationality in the capital flow directions, looking at the size, structure and profitability of capital invested in the USA by other countries (by China, among others) and in the rest of the world (in China, among others) by the USA. It turns out that about 50% of the world’s financial assets and as much as 60% of fluids and private financial assets are invested at the financial markets (shares and bonds) of the USA. The US financial markets owe their popularity in the world to the high degree of confidence towards American capitalism institutions (no nationalization risk and fast settling of disputes) and the fluidity of financial markets. Moreover, the American capital abroad reached considerably higher rate of return than the world’s capital in the USA, though the world’s investments’ value in the USA exceeded the US investments abroad by about 2,2 trillion dollars (i.e. the netto balance of the US investments abroad was negative).
What is interesting, only 35% of the world’s investments in the USA were invested in more risky companies’ shares that brought more long-term profits. At the same time, 61% of the American capital abroad was invested in shares. As a result, the average rate of profit for the world’s and China’s capital engaged in the USA was 6,2% in the years 1990-2005. During that period, the average rate of profit for capital that belonged to the US residents who “worked” abroad was 10% a year. Although the netto international investment balance of the USA is negative, the profitability of these investments exceeded the profitability of the foreign investments in the USA by 60% (10/6,2) on average. In other words, while China and other foreign countries are looking for safe investments in the USA by investing mainly in the US government bonds (the Department of the Treasury), the US residents are looking for high profit abroad. The USA can be said to fulfil the role of China’s and the world’s savings manager.
The USA is specialized in venture capital investments. The US Department of the Treasury fulfils the role of a financial intermediary. It issues bonds that have fixed and relatively low interest rates. Increasing the fluidity on the US financial market, it supports investing substantial funds in foreign assets and companies with relatively low risk. Since the crisis of 2008-2009, the USA has used its comparative advantage in exchanging the low-interest debt into shares with more risky and more profitable capital.
The major reasons for the US financial crisis 2008-2009
China invests large sums of money (2,3 trillion dollars of reserves) in the bonds of the US government, which increases their price and at the same time decreases their profitability and interest rates in the USA. Low real interest rates in the USA since 2001 have caused an artificial boom on the real property market. The price of the risk has decreased and the politization of the sub-prime mortgage market has become easier. The excessive love of risk is connected with the bad habit of breaking the invisible boundaries easily. The following story will show the excessive love of risk and the politization of the American real estate market and banking:
§ 1977: the US Congress passed the Community Reinvestment Act after race-based riots in Detroit in 1976 (43 killed, 3000 plundered buildings, 7200 arrested). The Act forced American banks to give home mortgage loans to people with low income, who had not fulfilled the traditional criteria.
§ 1999: revocation of Glass-Steagall Act (1933), which had forbidden linking low-risk (commercial) banking, i.e. accepting deposits from people with high-risk (investment) banking. Since then, great groups of banks, such as e.g. Citigroup, started creating securities based on high-risk mortgage loans.
§ 2000-08: credit default swaps (CDS) started securing uncertain mortgage loans. Their volume increased from 0,1 trillion dollars to 50 trillion dollars during the years 2000-08.
§ 2000: the Commodity Futures Modernisation Act exempted stock markets from supervising the Commodity Futures Trading Commission. It exempted high-risk transaction protection (CDS) and other derivatives from bank supervision and revoked extra requirements for reserves, audit and central transaction clearing etc.
§ 2000-05: gradual departure from the traditional requirement of deposit while acquiring real estate in order to “grant property rights” to the US residents. During these five years, the number of people who were exempted from deposit while buying real estate increased from 0,6% to 32,6%. About 10% of customers lived at homes bought exclusively on credit.
§ 2004: banking supervision (Securities and Exchange Commission) exempted five great American banks (Goldman Sachs, Merrill Lynch, Lehman Bros, Bears Sterns and Morgan Stanley) from the required traditional maximum ratio of equity to debt 8,3% (in 1901, this ratio had been 25%). Just before the crisis, this ratio in one of the greatest banks, the Bank of America, was 0,7%, i.e. 142 dollars of credit to 1 dollar of equity. The ratio takes into account commitments beyond the overall balance. The risk was taken.
§ 2000-08: derivative packets based on mortgage loans (collateralized debt obligations = CDO) paid higher interest rates that the US Treasury bonds, although reputable rating institutions assessed their insolvency risk at the highest “AAA” level. It was a sort of new economic law: “lower risk – higher profit”.
Too much risk tolerated by the authorities, mistakes in the financial policy of the Federal Reserve and the politization of the real estate market have become easier by the policy of China, which invests the current account surplus mainly, though not exclusively, in the bonds of the US government.
It can be stated that “Chimerism”, i.e. financial and economic symbiosis of the USA and China (the term quoted from the book The Ascent of Money by Niall Ferguson) is based on co-complementation of both political and economic systems. It is the symbiosis of:
- uncertain and incomplete property rights in the PRC and certain and complete property rights in the USA;
- an extensive increase and an intensive increase;
- low production factors’ effectiveness and high production factors’ effectiveness;
- investments in bonds of the government in return for investments in shares;
- the excessive fear from the risk and the excessive love of the risk;
- an underdeveloped financial system and an overdeveloped financial system;
- the export of goods and savings in return for the import of goods and the export of technologies.
This is the symbiosis of the law and quanxi, the symbiosis of authoritarianism and democracy.
Tłumacz: Marek Pinta ()