China’s extremely high interest rates, which seriously damage the economy, are a result of the fall in company profitability and overall savings. Central bank rate cuts will therefore not be enough to reduce interest rates unless company profitability and China’s savings can be increased – which requires throwing out the false theory of ‘consumer led growth.’
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When the People’s Bank of China recently announced the first interest rate reduction for two years this reflected an understanding that excessively high interest rates are a decisive problem for both private and state companies - and therefore for the economy as a whole. But, as will be analysed below, Central Bank action by itself will be unable to produce a substantial reduction in real interest rates without an overall correct macroeconomic policy. In this framework it is crucial to realise that China’s high interest rates are an inevitable consequence of the policies flowing from the erroneous theory of ‘consumer led growth’. Therefore, to ensure a serious interest rate reduction, it is necessary to understand clearly how this erroneous theory both damages the economy in general and in particular produces the problem of high interest rates.
First, to show how serious is both the domestic and international disadvantage China suffers from its high interest rates, Figure 1 shows the difference, the spread, between China’s interest rates on 10 year government bonds and that for equivalent bonds in the US. As state bonds provide the floor for long term borrowing rates, which are the key ones for company investment, this is the most suitable measure by which to compare Chinese and US interest rates.
As may be seen, China’s interest rates have moved from below those of the US in 2010 to sharply above US levels today. The overall rise in China’s relative rates compared to the US is approximately 2% - from 0.5% below US rates to approximately 1.5% above. China average commercial bank lending rates moved up exactly in parallel – rising, on average, from 5% in 2009 to 7% in 2014.
To understand clearly why China’s interest rates have risen so sharply it is necessary to remove fetishism and mystification regarding interest rates. An interest rate is merely a price – the price of capital. Like all prices, therefore, interest rates express the interrelation of supply and demand - for capital demand being constituted by investment and supply by savings. Therefore, for China’s interest rates to have risen, one of the following must necessarily have occurred.
- The interest rate fundamentally reflecting the balance of supply and demand for capital is the real, i.e. inflation adjusted, one. China’s nominal interest rates could, therefore, have increased if the balance of supply and demand for capital had not altered but inflation has risen. But this has not occurred. China’s CPI today is lower than in 2010 and the PPI has been falling. The real interest rate has risen - there has been no rise in inflation. Consequently there must have been changes in the supply or demand for capital.
- Analysing first demand for capital, that is investment, it may be seen in Figure 2 that in 2008-09, when China’s interest rates were below those of the US, China’s demand for capital was sharply expanding as a percentage of the economy. Total investment (fixed investment plus inventories) rose from 43.8% of GDP in 2008 to 48.1% of GDP in 2010. But despite this increase in the demand for capital China’s interest rates were at or below US levels. In contrast, between 2010 and 2013, the latest full year data, there was a marginal fall in the percentage of China’s investment in GDP – from 48.1% of GDP to 47.8% of GDP. Data for the full year 2014 is not yet available but it is clear that during this period the rate of increase of investment has been falling – the annual increase in fixed asset investment declining from 20.1% in October 2013 to 15.9% in October 2014.
The increase in interest rates in China since 2010, therefore, cannot be explained by an increase in the demand for capital, it must be due to a fall in the supply of capital.
- That a fall in the supply of capital in China has indeed taken place can be seen in Figure 3. Total savings (i.e. company savings, plus household savings, plus government savings) fell from 52.7% of GDP in 2009, and 52.0% in 2010, to 50.8% in 2013. Given this drop in the supply of capital, as demand had not fallen, a rise in real interest rates was inevitable – precisely as has occurred.
Taking a long term trend, it can be seen from Figure 4 that until 2009 the proportion of China’s economy constituted by savings was rising – this paralleled an increase in the percentage of GDP constituted by company profits. This period, as is well known, was accompanied by rapidly increasing living standards and fast economic growth. After 2009, however, the proportion of China’s economy consisting of capital supply, that is savings, declined. This paralleled the end of expansion of company profitability as a percentage of GDP, and was accompanied by a substantial deceleration in economic growth.
The rise in China’s interest rates is simply an inevitable expression of this fall in the supply of capital. As high market interest rates for long term capital are a necessary result of the fundamental shift in the relation between demand and supply of capital they cannot be lowered by technical means such as alterations in the types of financial instruments available. Furthermore, while a Central Bank can set and control short term money market rates, it cannot set long term lending interest rates as these are determined by this market balance of supply and demand. This firm prediction of theoretical economics has been repeatedly confirmed even in the case of the world ‘s most powerful Central Bank, the US Federal Reserve, while in China in the last two years short term money market rates have fluctuated strongly under the impact of Central Bank interventions but the average rate for lending to companies has remained at 7%.
Given that the rise in interest rates is due to the fall in the supply of capital the key question for reducing interest rates is, therefore, how to raise the supply of capital, i.e. savings. As total savings have three potential sources – from households, companies and the state – each must be examined.
- Household savings are determined by two key factors – first by total household income, second by the division of income between consumption and saving. As household income is received by individuals, who can therefore decide whether to spend or save, it is difficult to directly influence how households divide income between consumption and savings - unless compulsory savings schemes are introduced, as were used in Singapore. Theoretically, increasing interest rates for individual depositors might increase savings, but evidence does not show a close correlation between interest rates and savings. Furthermore, as the aim is to reduce interest rates, raising rates to household savers would tend to put upward pressure on overall interest rates in the economy as a whole rather than secure the key goal of reducing them. The concept of ‘consumer led growth’ seeks to increase the proportion of the economy devoted to consumption by one of two routes - or both. The first is to increase the share of wages in the economy. The second is to reduce the proportion of household income which is saved – i.e. people should be encouraged to spend a higher proportion of their income. Which of the two is followed does not matter for the direct issue of household savings – other things being equal, either shift will increase the percentage of the economy devoted to consumption, thereby reduce the savings level, and therefore, other things remaining equal, put upward pressure on interest rates.
- Which of the two methods of increasing household consumption is followed, however, has a very strong effect on the second source of savings - companies. The theory of ‘consumer led growth’ typically argues that the economy’s wages should be increased so as to raise the purchasing power available for consumption. But increasing the economy’s wages share, via wages growing more rapidly than GDP, necessarily means reducing the profits share – thereby putting downward pressure on company profitability. It has recently been pointed out that for somewhat different reasons excessive wage increases damage China’s companies. However downward pressure on profits from excessive wage rises directly reduces company profitability – a key explanation of the low rate of growth of profits in the recent period. From 2000 to 2007 the percentage of profits in GDP rose from 19% to 31%. Since that time the percentage of profits in GDP has ceased increasing – constituting a key reason the overall share of savings in the economy stopped rising.
- Government savings are the smallest source of total savings, indeed they are normally negative as the state runs a budget deficit - although China’s deficit is small compared to most countries. However, the budget deficit is one of the easiest determinants of savings to adjust, as this can be achieved by administrative decisions increasing taxation or lowering spending. Regarding which of these two to choose in order to increase the savings level, it should be noted that China’s state spending level is very low compared to advanced economies – primarily reflecting the lack of a system of social protection in properly adequate pension, health care etc. provisions. As a result, in 2013, on IMF internationally comparable data, China’s state income was only 22% of GDP, compared to 33% for the US. China’s government expenditure was also only 25% of GDP compared to the US 38% - figures for other developed economies are higher. Therefore reducing the state budget deficit by reducing expenditure would cut across China’s path of economic development – making it impossible to create the types of systems of social security of the US and other advanced economies, with highly undesirable economic and social consequences. China’s tax system, in contrast, is very undeveloped compared to advanced economies. Many taxes taken for granted in advanced economies, for example property and inheritance taxes, do not even exist in China. An increase in taxes would therefore be one of the quickest ways to increase China’s savings level. In order to avoid social unrest, tax increases should of course be concentrated on the best off – which, in addition to its economic benefits, would also have the desirable social goal of reducing inequality.
The alternative ways to reduce interest rates, as opposed to raising savings, are all damaging for China’s economy, living standards and social stability.
Regarding fixed asset investment, the substantial fall in the rate of increase of this is already the primary reason for the major downward pressure on economic growth in the last two years. Beyond this purely short term, modern econometrics shows that capital investment is overwhelmingly the most important source of economic growth. On average in advanced economies 57% of growth is due to capital investment, 32% to increase in labour inputs, and only 11% to increases in total factor productivity (TFP). China’s economy is already decelerating, and reducing investment levels would, therefore, necessarily lead to a further substantial slowdown in economic growth with extremely undesirable consequences for both companies and individuals.
- For companies, slower revenue growth, an inevitable consequence of economic deceleration, will put further downward pressure on profits - recent data shows profit of China’s industrial enterprises actually fell 2.1% in the year to October. This reality illustrates, once again, that those who argue for a theory of ‘consumer led growth’ do not actually understand the nature of a market economy. An increase in consumption, if it does not lead to an increase in profits, will not lead to strong ‘growth’ but on the contrary, at best, to slower economic growth - or even more negative trends. In a market economy nothing is produced because someone wishes to consume it, it is only produced if it produces a profit. A market economy can therefore necessarily only have ‘profits led growth’ – not ‘consumer led growth.’ Wage increases which decrease profits share in GDP may lead to a higher desire to consume but, by reducing profits, they will actually weaken economic growth.
- Regarding individuals, internationally 86% of increases in consumption are due to economic growth. The false idea that living standards in China can primarily be raised by redistributing existing GDP to consumption is merely a ‘rightest’ version of the ultra-left fallacy that ‘prosperity can be achieved by sharing out poverty.’ China’s per capita GDP in 2013 was only 13% of US levels at current exchange market rates, and 22% measured in PPPs. This means that even if the share of consumption in China’s GDP were raised to US levels, China’s consumption per person would only be one eighth of that of the US at market exchange rates and less than one quarter in terms of PPPs. The idea that a level of consumption in China of only one eighth/one quarter of the US is satisfactory, or constitutes prosperity, is ridiculous. China can only draw closer to advanced economies’ living standards by growing more rapidly than they do for a prolonged period. And the key to GDP growth, as already shown, is investment. Increasing consumption’s percentage of GDP, which necessarily means reducing the percentage of investment, would by slowing economic growth, even if it raised living standards in the very short term, therefore lead to substantially lower living standards over the medium and long term.
The claim, which is sometimes made, that increased savings are undesirable because they decrease demand, an argument which it is said flows from ‘Keynesianism,’ is entirely fallacious– and has nothing to do with the ideas of Keynes. Demand, as Keynes understood, consists of two components – consumption and investment – and does not just consist of consumption. Increased saving, provided it is invested, therefore leads to no decrease in demand at all.
Finally, in addition to its damaging structural consequences, economic trends in line with the false theory of ‘consumer led growth’ also explain why monetary stimulus has become decreasingly effective in China – i.e. any given increase in credit produces less growth than previously. As company growth can only be ‘profits led’, attempts to pursue ‘consumer led growth,’ by putting downward pressure on company profitability, therefore means companies will respond by less expansion to any credit or monetary stimuli. Decreasing responsiveness of economic growth to credit or monetary expansion is therefore an inevitable consequence of the end of the situation where the economy’s profits and savings share was rising.
In short, the concept of ‘consumer led growth’ was always false from the point of view of economic theory, but it has now become directly practically damaging economically. China faces objective pressure for a decrease in the economy’s profits share, and a fall in the savings level – due to the end to the increase in the working age population, the consequent slowing of the increase in the labour supply, and therefore pressure for wages to increase more rapidly than GDP. But the theory of ‘consumer led growth’, instead of seeking to limit these effects, seeks to amplify them.
The erroneous theory of ‘consumer led growth’ therefore has numerous negative consequences for China’s economy. But one of the most serious, at present, is the way it leads to high interest rates. In order to have a correct economic map, and most immediately to reduce interest rates, it is therefore necessary to abandon the theoretically false and practically damaging concept of ‘consumer led growth’ and instead to begin rebuilding China’s savings level.
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This article was originally publised in Chinese under the title 'Central Bank action alone will not be enough to cut interest rates' on Sina Finance on 1 December 2014.