America’s two big imbalances at the start of the crisis in 2007 were unaffordable household debt and a persistently excessive real exchange rate. When the first of these precipitated the crisis, and China’s downward manipulation of its currency prevented a proper cure for the second, the halting US recovery required a third imbalance: huge government deficits that ensured a soaring ratio of public debt to gross domestic product.
Since 2009, the household debt problem has been largely solved. Meanwhile China’s soaring wage costs have cut the US real exchange rate “through the back door”. And the budget deficit, 12.5 per cent of GDP at its 2009 peak, had fallen to 8.5 per cent by mid-2012. All this deleveraging has ensured a weak recovery.
Yet the deficit needs to be cut further. With trend growth of 2-2.5 per cent, and inflation close to 2 per cent, keeping US public sector debt (now 90 per cent of GDP on the Fed’s measure) below 100 per cent will require a budget deficit less than nominal growth, of about 4 per cent. Hence the US fiscal cliff (planned spending cuts and tax rises that would reduce the deficit), and the threat of disappointing growth in 2013. But the upside potential is there. If the cliff does turn out to be large – our forecast is that budget tightening in 2013 will be 2-2.5 per cent of GDP – most of the needed budget adjustment will have been achieved, and the stage will be set for a strong recovery from 2014.
An important aspect is the role of default. Default and/or devaluation (a form of default from the standpoint of foreigners) is normally needed to emerge from a debt crisis. Sure enough, the cuts in US household debt from 130 per cent of disposable incomes to 110 per cent have largely occurred through default (bank write-offs) with a modest benefit from growing incomes. And the slashing of interest rates below inflation, which has also helped make current debts readily affordable by past standards, might also be regarded as a form of clandestine default.
So much for household debt, but what about US government debt? Imagine you are China’s People’s Bank, with up to $3tn of Treasuries. The interest rate is zero. The dollar has been falling 3-5 per cent a year against the renminbi. And Chinese consumer inflation has averaged 4 per cent or so, though now it is down below 2 per cent. In real renminbi, those dollars have been falling at a rate of about 8 per cent. “No default, please, we’re American” – but it feels like a big loss to the Chinese.
Domestically, China continues to build up its own bubble of debt that will probably never be repaid in full. And its refusal to reverse the policies that underlie this build-up is why its growth may halve to 5 per cent in the next few years. Without a sharp shift of policy, that 5 per cent may be the upper limit of Chinese growth for the long term, with a plague of banking crises threatening a worse result.
This would be a disastrous result for a country whose per capita GDP (at comparable prices) is just 17 per cent of the US level, versus 67 per cent in 1973 in Japan, when its growth likewise halved to 5 per cent.
China’s huge savings rate was 51 per cent of GDP in 2011, slightly up from pre-crisis 2007. Its pre-crisis means of disposing of this excess of saving (and product) was a 10 per cent of GDP current account surplus, essentially relying on US households to borrow the money and buy the goods – which they gladly did until the subprime crisis stopped them in their tracks. China’s response to the crisis was strong stimulation of both exports and investment – the two standard sources of growth in the past. As a result, investment by 2011 was 48 per cent of GDP, and the inflation resulting from this policy had wiped out China’s export cost advantage. The “right rate” of investment, if China is to grow at 7-8 per cent in future, is at most 35 per cent of GDP. So the economy has been taken in the wrong direction for the past four years.
Of China’s savings, nearly 40 per cent of GDP is concentrated in the business sector, yet does not translate into spending without passing through the financial system. Investment is not being done by those who are profitable, but elsewhere.
Debt is building up, and will have to be written off. The financial liberalisation China needs – no more interest rate and exchange controls, flotation of the renminbi – would provoke an immediate banking crisis. But that will happen in due course anyway, and reform and recapitalisation are better done sooner than later.
Talk of reform is all well and good, but action is what counts.
Charles Dumas is chairman of Lombard Street Research