The potential hazards of a global savings glut

The opening day of the annual Strategic and Economic Dialogue between the governments of the United States and China kicked off in Beijing, with one of the many topics of discussion being the exchange rate between the U.S. dollar and the Chinese yuan. China keeps the value of its currency artificially low vis a vis the greenback through exchange rate mechanisms. The U.S. government consistently criticizes this strategy on the grounds that it unfairly adds to the U.S. trade deficit, but the concerted effort also contributes to the Chinese savings rate, which may also affect the stability of national economies and the entire international economy.

Any exchange rate influences the flow of goods between countries. In the case of the United State and China, more Chinese goods flow into the United States because a lower exchange rate spurs Chinese exports. Yet the exchange rate also affects the flow of capital because it increases the flow of capital into and out of the Chinese economy. The change in the current account, more or less the trade balance, is the same in size as the change in the capital account, the flow of capital, but in the opposite direction.

By making imports more expensive, the manipulated exchange rate also encourages domestic savings. The increased savings can affect economic stability in two ways. First of all, it may promote a bubble within the domestic economy. After decades of promoting an investment-first growth strategy, China appears to be approaching a slowdown as building construction has started to decline. A shift toward a growth strategy where increased earnings are used to increase consumption would be a more stable path.

Of course, Chinese savings don’t necessarily stay within the Chinese economy. They are often invested abroad including in the United States. That’s why we’re seeing more Chinese ownership of U.S. assets. In fact, manipulating the exchange rate requires China’s central bank to make very large-scale purchases of greenbacks and U.S. dollar-denominated assets. The result is a large pool of cash looking for investment opportunities.

One can argue, and some economists have, that the large pools of cash built up by China, other countries and institutional investors contributed to the development of the shadowing banking system, or the system of non-bank financial institutions that perform bank-like activities. The unregulated shadow banking system was a key mechanism in the financial crisis of 2008, helping to propagate the losses from the mortgage market through the entire financial system.

Whether the problem is too much savings or a lack of viable investment opportunities, the fact remains that large institutional investors, even countries, are looking for safe places to store their savings. This trend seems to have significant ramifications for economic growth and stability. The search for financial safety may produce the opposite result.