My Blog

April 6, 2008

SUN 6 APR

The savings glut is looking for a new equilibrator By Michael Pettis

As I have mentioned many times on this blog I am one of those who sees the great global imbalances of the present period as largely a consequence of a global savings glut, and as the biggest saver China is one of the most important players in this process.  As the system is currently undergoing a great deal of stress, it is going to be forced to change one way or the other, and there is no reason to believe this change must be benign, either for the world or for China.

 

How does the savings glut work?  In recent years we have seen a combination of a structural savings glut (mercantilist policies in a number of countries, especially in Asia, have included a rigid currency regime which exports high domestic savings) and a cyclical savings glut (commodity exporters, especially oil exporters, have seen export earnings grow much faster than imported consumption).  The combination of these two has resulted in a vast building up of foreign currency reserves among the saving countries.  The accumulation of foreign reserves is largely the consequence of accumulated trade surpluses, which because they imply total consumption that is less than total production, is the way in which domestic savings – forced or otherwise – is exported to the rest of the world.

 

In a system in which most countries of the world are tied together by trade and capital flow links, a savings glut of course does not mean that there has been a net increase in global savings.  It means that excess savings in one part of the system will automatically lead another part of the system into excess consumption so as to keep the overall system in balance.  With its very flexible financial system, its deep pockets, and the high credibility of its financial markets (not to mention the eagerness of many of its citizens to increase consumption), it is no surprise that the US economy and financial system have been the great equilibrator, running the significant trade deficits over the past several years needed to match the mercantilist and commodity-export-related surpluses of those countries with surplus savings.

 

But falling house prices and slowing demand are forcing the US to increase its own savings rate and so to reduce its ability to balance the excess savings abroad – we can see this by noting the rapidly declining US trade deficit.  A world of excess savings, in other words, is being forced into an adjustment in which the savings of its largest economy is set to grow – and it cannot be a good idea to increase savings in a world that is already experiencing a savings imbalance of this sort.  

 

Of course this adjustment cannot happen in a vacuum, and either the excess savers must cut savings and increase consumption, or another very large and credible economy must take up the US consumption slack.  The former certainly does not look like it is happening, and in fact it cannot happen as long as the excess-savers’ central banks keep intervening in the markets to keep their currency values low – their intervention is the very process by which high domestic savings are exported to the rest of the world.

 

So the latter is happening.  Europe is being forced to absorb an increasing share of the savings imbalances as the US reduces its share.  As I have often written here, I am very skeptical about whether Europe has the financial or economic flexibility, or the political flexibility for that matter, to replace the US as the great equilibrator.  But what is the alternative?  Even if global savings are eventually reduced by declining commodity prices, I see little evidence that the mercantilist savers are bringing their consumption levels up quickly enough to enable the global economy to regain some balance.

 

That suggests to me that at some point, perhaps quite soon, European trade imbalances will be high enough to cause significant problems at home.  Either Europe will react by trying to limit imports, or the euro will crash against the dollar, sending the role of equilibrator back to the US, or mercantilist savings will decline sharply and maybe even reverse.  As I see it these are the only three likely options to restore balance.  Neither is likely to be benign, but I guess the trick is to figure which of these is likely to be the less damaging and work towards that direction.

 

Meanwhile, and as an aside, Friday’s South China Morning Post has a story on QDIIs, a subject I have covered a lot in this blog because QDIIs act as a sort of proxy for speculative interest and they indicate one of the ways in which China is trying to diversity the exporting of its excess savings.  China’s QDII’s, which are funds specifically designed to allow Chinese investors to invest abroad (capital controls prevent foreigners from easily investing in China and Chinese from easily investing abroad) seem to be under continued pressure from disgruntled investors who are fed up with the losses they have taken.  An article titled “Mainland funds deny QDII cash pressure,” has this to say:

 

Beleaguered mainland fund managers have denied they are facing pressure from investors who want to cash out of their qualified domestic institutional investor products in Hong Kong.  The QDII scheme, which allows mainlanders to invest in foreign markets such as Hong Kong through approved funds, has come under close scrutiny after Minsheng Bank was forced to liquidate a product late last month after the net asset value fell by more than 50 per cent.

 

“We don't feel redemption pressure,” the article quotes Zhang Houqi, the deputy president of China Asset Management, as saying.  China Asset Management was one of the first mainland fund houses to embark on the QDII scheme.  The story goes on: “Analysts said QDII funds were being forced to increase their cash positions before potential heavy redemptions since the first batch of buyers wanted to cut losses.”

 

When managers are busy assuring the market that they don’t feel redemption pressure, that is usually a sign that there is redemption pressure, isn’t it?  After all it is not hard to think of the name of one or two banks who recently told us that they were not under liquidity pressure, only subsequently to find that indeed they were.

 

If there are sufficient redemptions in the next few weeks or months that force these funds to liquidate, I suppose we will see a jump in the already high monthly increases in central bank reserves, as money which previously left the country (and so relieved the PBoC from mopping it up) returns to the perceived safety and relative high returns of Chinese bank deposits.