In the late 1990s, a severe savings shortage developed in the United States. Increased private sector capital investment spending accompanying the IT bubble produced a gaping current account deficit. When the IT bubble burst in 2000, the Federal Reserve Board scrambled to cut interest rates with the aim of generating an economic recovery, while the U.S. government implemented a fiscal stimulus package that added to the fiscal deficit. As the expansion of the fiscal deficit was much larger than the decline in private investment, the current account deficit widened.
With the emergence of the housing investment bubble in the mid-2000s, the private sector saved even less and the current account deficit expanded further. If we look at the subsequent global financial crisis that originated in the U.S., it is evident that the housing investment bubble was fostered by subprime mortgages and subprime mortgage backed securities.
As the U.S. savings shortage persevered, capital inflows from foreign countries became essential to inflate the housing market bubble. Although the capital inflows were provided directly through European financial institutions, it is conceivable from a macroeconomic perspective that the current account surpluses building up in oil-exporting countries in the Middle East and Russia were being invested in the U.S. housing market.
When the subprime mortgage problem first surfaced in the summer of 2007, European financial institutions that had invested assets in structured products related to subprime mortgage began to trim their balance sheets substantially. In an environment of heightened counterparty risk, the exchange rates of both the euro and the sterling pound plunged against the U.S. dollar as excess demand for the dollar made it difficult to procure dollar funds, which led to a liquidity shortage of the dollar. One important lesson from this experience is that it was not the U.S. currency at the epicenter of the global financial crisis that crashed, but the currencies of European countries whose current accounts were relatively well balanced.
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Since the late 1990s, the global imbalance (globally unbalanced current accounts) has been acknowledged as a problem. As the U.S. current account deficit expanded, it was not only the current account surpluses of oil-exporting countries such as the Middle Eastern countries and Russia that were growing, but also the surpluses of East Asian countries with high savings rates such as Japan and China. Fed Chairman Ben Bernanke has pointed out how extraordinary the high savings rates in East Asian countries have been by noting that their excessive savings gave birth to their current account surpluses, which in turn facilitated the fiscal deficit, excessive capital formation and housing investments in the U.S., ultimately causing the U.S. current account deficit to expand and the global imbalance to worsen.
It is true that the U.S. current account deficit could not have increased without any financing support from countries with current account surpluses. However, as countries with current account surpluses are mirror images of countries with current account deficits, it seems pointless to try to identify which country is the culprit responsible for the global imbalance.
Former Treasury Secretary Henry Paulson also pointed out that the savings glut in countries like China spread risk throughout the world. Nevertheless, even if the savings are in fact excessive, the assertion that risk is diffused around the world because of excessive savings is contrary to the facts. Financial institutions in East Asian countries including Japan and China did lose as much from subprime-related structured products as did their European and American counterparts. In other words, it is not true that the savings glut in East Asian countries stimulated the U.S. housing investment bubble through subprime mortgage backed securities.
If the savings glut in East Asian countries had formed the backdrop of the U.S. housing investment bubble, all East Asian currencies, including the yen and the yuan, should have collapsed much more dramatically than the sharp fall of the euro, given that the dollar is the major currency used in economic transactions both inside and outside the region. In reality, however, the excess savings in East Asian countries were invested in U.S. government bonds, which means that they were financing the unsustainable U.S. current account deficit that arose from the U.S. fiscal deficit. In that context, the excess savings in East Asian countries should in fact be praised for reducing the risk of the dollar collapsing, an event that could have occurred had the unsustainable U.S. current account deficit not been financed.
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Nevertheless, things will be different if we think about how to solve the global current account imbalance. Based on the view that China rather than the U.S. should work on correcting the imbalance, some insist that China should excessive savings, while others say that it should revalue the yuan, in particular, to reduce its current account surplus. I will discuss below whether it is necessary for China to eliminate excessive savings, revalue the yuan, or a combination of both.
In an economy where wages and prices are flexible, the gross domestic products (GDP) will settle at the level of full employment, which will then determine the size of savings, and the gap between savings and investment will determine the balance of the current account. In a flexible economy, it is therefore the size of savings, not the exchange rate, which will adjust the current account imbalance.
On the other hand, in an economy where wages and prices are sticky, GDP will not always be determined by the level of full employment. In other words, since capital relatively quickly flows cross boarders, even in this situation, and the exchange rate is determined first, the exchange rate can be a tool for adjusting the current account imbalance. If we sort out the economy as described above, we may conclude that eliminating excess savings is incompatible with the revaluation of the yuan. Since we cannot determine a priori which claim is more realistic, a conclusion must be drawn based on empirical analysis.
The results of an empirical analysis conducted by the author and Associate Professor Kentaro Iwatsubo of Kobe University on the elimination of current account imbalances in East Asian countries, based on the theoretical framework mentioned above, found that both wages and prices are flexible in China, and that savings are the main determinant of the current account balance. The empirical results also proved that the exchange rate is an effective instrument for adjusting China's current account imbalance in the short-run, but ineffective in the long-run. A reduction in savings will therefore be more effective at reducing China's current account surplus than a revaluation of the yuan. To put it another way, although excess savings are not necessarily the cause of the current account surplus in China, reducing savings and increasing consumption would be more effective at reducing the surplus than would revaluing the yuan.
In Japan, on the other hand, it has become evident that the size of GDP has an impact on the current account balance through savings, and that the exchange rate has a relatively large impact on the current account balance. In other words, in Japan it is more effective to adjust the current account balance via the exchange rate than by reducing savings.
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Reducing savings in China would mean shifting a predominantly external demand-oriented economy to one more oriented toward domestic demand. In Japan, in contrast, reducing the savings rate would not have the same impact on lowering the current account surplus as it would in China because, relatively speaking, the tendency of the Japanese economy to rely on external demand is not as strong as it is in China.
Household savings in China have been increasing sharply in recent years, with the 2008 year-end balance of household savings 26.3% higher than the previous year. The major cause for this sharp rise is heightened social anxiety about the future, as China's social security system (including pension and medical systems) is undeveloped. Given that such a tendency runs counter to reducing the current account surplus, attention should be paid to the fact that the shift to a domestic demand-oriented economy could become even more difficult.
To reduce its current account surplus, China must first develop a social security system capable of alleviating anxiety about the future before it can correct its tendency for excessive household savings. In this regard, it is hoped that of the four trillion yuan (approximately ¥52 trillion) fiscal stimulus package recently announced by the Chinese government, a greater amount will be spent on the social security system than on infrastructure such as the railway network. It is possible to expect that the recently established minimum wage law will also increase consumption by guaranteeing income for low-wage earners, although the law is a double-edged sword in the sense that it will result in increasing labor costs for firms at the same time.
* Translated by RIETI.
February 17, 2009 Nihon Keizai Shimbun
