Does China save and invest too much?

• Author: Makin, John H.

China's current saving and investment levels are extraordinary--both in terms of its own history, but also by comparison with the current and historical experience of high-saving countries like Japan. The International Monetary Fund's 2005 World Economic Outlook places China's gross saving at 50 percent of GDP with gross capital formation, not far behind, at 45 percent of GDP (IMF 2005: 96-97).

High levels of saving and investment are usually seen as a good thing. For a developing economy, such as China, a high level of domestic saving and investment means that residents are forgoing current consumption in order to add to the capital stock, thereby increasing growth and labor productivity. For a developed economy like the United States, while absolute levels of saving and investment may not match those in developing economies, a high level of saving and investment would mean that residents are financing most of the increase in the capital stock and are thereby positioning themselves to benefit from future returns earned by the enlarged capital stock. The reality for the United States over the past half-decade--a sharp rise in imports of foreign savings--means that returns from growth in the capital stock are increasingly earmarked for payment to foreign investors.

Despite the satisfaction with which most commentators view its high levels of saving and investment, particularly since 2002, China has displayed increasing signs of overinvestment. As used here, the term overinvestment refers to a capital stock either too large or too poorly allocated to generate positive returns at the margin. Misallocated capital and excess capacity in the domestic sector implies a rapid increase in nonperforming loans, which are largely held by China's state banks. Excess capacity in the tradable goods sector implies a tendency to undervalue the exchange rate in order to maintain the growth of demand for exportables.

The problem with currency undervaluation is that it results in excessive domestic growth of liquidity, which combined with an inability to diversify savings abroad, results in excessive speculation in the nontradable goods sector such as real estate and land. The Chinese government stepped in during 2003 to slow credit creation.

The sharp drop in China's loan growth from a peak of nearly 25 percent year-over-year annually in 2003 to about 13 percent in 2005 and early 2006 has created a cash-flow crisis. The response by enterprises in the tradable goods sector has been to boost sales abroad while curtailing foreign purchases. China's overall trade surplus reached a record $102 billion in 2005, a 23 percent increase over 2004. This explosion of China's trade surplus has been concentrated on the United States, resulting in trade tensions and calls for China to revalue its currency. However, the real problem lies with China's reluctance to allow its huge saving flows to move abroad and thereby to provide a Chinese population that is rapidly accumulating wealth with adequate choices on where to store that wealth.

China's government has undertaken the wealth storage role for the nation by investing heavily in U.S. government securities, mortgage-backed securities, and European bonds. The half-trillion dollars (an extraordinary one-third of GDP) it has acquired in foreign exchange reserves since 2002, while intervening to prevent the appreciation of its currency, represents a government decision to accumulate wealth in the form of claims on U.S. and European governments and financial intermediaries while subsidizing its tradable goods sector with an undervalued exchange rate. China is suppressing demand growth at home while stimulating it in advanced countries by accommodating borrowing and demand growth abroad. In short, part of the explanation for low real interest rates worldwide is global excess capacity. In China, if savers could earn high real returns on capital investment at home, financial capital would flow from the United States to China, not the other way around.

This path for China, not to mention the world economy, is unsustainable. Not because the numbers are so large, but rather because it is destabilizing. China's chronic excess capacity problem has been suppressed in the domestic sector by a credit crunch wherein companies simply do not pay for the inputs they purchase while increasingly relying on accommodation of the state banking sector. Meanwhile, in the tradable goods sector, Chinese exports are on offer as the low-price supplier in most markets while imports have been sharply...