MAR 30, 2013

When Interest Rates Rise

CAMBRIDGE Long-term interest rates are now unsustainably low, implying bubbles in
the prices of bonds and other securities. When interest rates rise, as they surely will, the
bubbles will burst, the prices of those securities will fall, and anyone holding them will be
hurt. To the extent that banks and other highly leveraged financial institutions hold them,
the bursting bubbles could cause bankruptcies and financial-market breakdown.
The very low interest rate on long-term United States Treasury bonds is a clear example
of the current mispricing of financial assets. A ten-year Treasury has a nominal interest
rate of less than 2%. Because the inflation rate is also about 2%, this implies a negative
real interest rate, which is confirmed by the interest rate of -0.6% on ten-year Treasury
Inflation Protected Securities (TIPS), which adjust interest and principal payments for
inflation.
Historically, the real interest rate on ten-year Treasuries has been above 2%; thus,
todays rate is about two percentage points below its historical average. But those
historical rates prevailed at times when fiscal deficits and federal government debt were
much lower than they are today. With budget deficits that are projected to be 5% of GDP
by the end of the coming decade, and a debt/GDP ratio that has roughly doubled in the
past five years and is continuing to grow, the real interest rate on Treasuries should be
significantly higher than it was in the past.
The reason for todays unsustainably low long-term rates is not a mystery. The Federal
Reserves policy of long-term asset purchases, also known as quantitative easing, has
intentionally kept long-term rates low. The Fed is buying Treasury bonds and long-term
mortgage-backed securities at a rate of $85 billion a month, equivalent to an annual rate
of $1,020 billion. Since that exceeds the size of the government deficit, it implies that
private markets do not need to buy any of the newly issued government debt.
The Fed has indicated that it will eventually end its program of long-term asset purchases
and allow rates to rise to more normal levels. Although it has not indicated just when rates
will rise or how high they will go, the Congressional Budget Office (CBO) projects that the
rate on ten-year Treasuries will rise above 5% by 2019 and remain above that level for
the next five years.
The interest rates projected by the CBO assume that future inflation will be only 2.2%. If
inflation turns out to be higher (a very likely outcome of the Feds recent policy), the
interest rate on long-term bonds could be correspondingly higher.
Investors are buying long-term bonds at the current low interest rates because the
interest rate on short-term investments is now close to zero. In other words, buyers are
getting an additional 2% current yield in exchange for assuming the risk of holding longterm bonds.
That is likely to be a money-losing strategy unless an investor is sagacious or lucky
enough to sell the bond before interest rates rise. If not, the loss in the price of the bond

would more than wipe out the extra interest that he earned, even if rates remain
unchanged for five years.
Here is how the arithmetic works for an investor who rolls over ten-year bonds for the
next five years, thus earning 2% more each year than he would by investing in Treasury
bills or bank deposits. Assume that the interest rate on ten-year bonds remains
unchanged for the next five years and then rises from 2% to 5%. During those five years,
the investor earns an additional 2% each year, for a cumulative gain of 10%. But when
the interest rate on a ten-year bond rises to 5%, the bonds price falls from $100 to $69.
The investor loses $31 on the price of the bond, or three times more than he had gained
in higher interest payments.
The low interest rate on long-term Treasury bonds has also boosted demand for other
long-term assets that promise higher yields, including equities, farm land, high-yield
corporate bonds, gold, and real estate. When interest rates rise, the prices of those
assets will fall as well.
The Fed has pursued its strategy of low long-term interest rates in the hope of stimulating
economic activity. At this point, the extent of the stimulus seems very small, and the risk
of financial bubbles is increasingly worrying.
The US is not the only country with very low or negative real long-term interest rates.
Germany, Britain, and Japan all have similarly low long rates. And, in each of these
countries, it is likely that interest rates will rise during the next few years, imposing losses
on holders of long-term bonds and potentially impairing the stability of financial
institutions.
Even if the major advanced economies current monetary strategies do not lead to rising
inflation, we may look back on these years as a time when official policy led to individual
losses and overall financial instability.

AUG 28, 2013

US Interest Rates Will Continue to Rise

CAMBRIDGE Six months ago, I wrote that long-term interest rates in the United States
would rise, causing bond prices to fall by so much that an investor who owned ten-year
Treasury bonds would lose more from the decline in the value of the bond than he would
gain from the difference between the bonds interest rate and the interest rates on shortterm money funds or bank deposits.
That warning has already proved to be correct. The interest rate on ten-year Treasury
bonds has risen almost a full percentage point since February, to 2.72%, implying a loss
of nearly 10% in the price of the bond.
But what of the future? The recent rise in long-term interest rates is just the beginning of
an increase that will punish investors who are seeking extra yield by betting on long-term
bonds. Given the current expected inflation rate of 2%, the real rate on ten-year bonds is
still less than 1%. Past experience implies that the real rate will rise to at least 2%, taking

the total nominal interest rate to more than 4%, even if expected inflation remains at just
2%.
The interest rate on long-term bonds has been kept abnormally low in the past few years
by the Federal Reserves unconventional monetary policy of buying massive amounts of
Treasury bonds and other long-term assets so-called quantitative easing (QE) and
promising to keep short-term rates low for a considerable period. Fed Chairman Ben
Bernankes announcement in May that the Fed would soon start reducing its asset
purchases and end QE in 2014 caused long-term interest rates to jump immediately.
Although Bernankes announcement has focused markets on exactly when this tapering
will begin and how rapidly it will proceed, these decisions will not affect the increased
level of rates a year or two from now.
The promise to keep the overnight interest rate low for an extended period was intended
to persuade investors that they could achieve higher returns only by buying long-term
securities, which would drive up these securities prices and drive down their yields. But
the current version of this promise not to raise the overnight interest rate until the
unemployment rate drops below 6.5% no longer implies that short-term rates will
remain low for an extended period.
With the unemployment rate currently at 7.4% having fallen nearly a full percentage
point in the last 12 months markets can anticipate that the 6.5% threshold could be
reached in 2014. And the prospect of rising short-term rates means that investors no
longer need to hold long-term bonds to achieve a higher return over the next several
years.
Although it is difficult to anticipate how high long-term interest rates will eventually rise,
the large budget deficit and the rising level of the national debt suggest that the real rate
will be higher than 2%. A higher rate of expected inflation would also cause the total
nominal rate to be greater than 5%.
Todays investors may not recall how much interest rates rose in recent decades. The
interest rate on ten-year Treasuries increased from about 4% in the mid-1960s to 8% in
the mid-1970s and 10% in the mid-1980s. It was only at the end of the 1970s that the
Fed, under its new chairman, Paul Volcker, tightened monetary policy and caused
inflation to fall. But, even after disinflation in the mid-1980s, long-term interest rates
remained relatively high. In 1985, the interest rate on ten-year Treasury bonds was 10%,
even though inflation had declined to less than 4%.
The greatest risk to bond holders is that inflation will rise again, pushing up the interest
rate on long-term bonds. History shows that rising inflation is eventually followed by
higher nominal interest rates. It may therefore be tempting to invest in inflation-indexed
bonds, which adjust both principal and interest payments to offset the effects of changes
in price growth. But the protection against inflation does not prevent a loss of value if real
interest rates rise, depressing the value of the bonds.
The relatively low interest rates on both short-term and long-term bonds are now causing
both individual investors and institutional fund managers to assume duration risk and

credit-quality risk in the hope of achieving higher returns. That was the same risk strategy
that preceded the financial crisis in 2008. Investors need to recognize that reaching for
yield could end very badly yet again.

JUN 28, 2013

Why Is US Inflation So Low?

CAMBRIDGE Why has quantitative easing coexisted with price stability in the United
States? Or, as I often hear, Why has the Federal Reserves printing of so much money
not caused higher inflation?
Inflation has certainly been very low. During the past five years, the consumer price
index has increased at an annual rate of just 1.5%. The Feds preferred measure of
inflation the price index for personal consumption expenditures, excluding food and
energy also rose at a rate of just 1.5%.
By contrast, the Feds purchases of long-term bonds during this period has been
unprecedentedly large. The Fed bought more than $2 trillion of Treasury bonds and
mortgage-backed securities, nearly ten times the annual rate of bond purchases during
the previous decade. In the last year alone, the stock of bonds on the Feds balance
sheet has risen more than 20%.
The historical record shows that rapid monetary growth does fuel high inflation. That was
very clear during Germanys hyperinflation in the 1920s and Latin Americas in the
1980s. But even more moderate shifts in Americas monetary growth rate have translated
into corresponding shifts in the rate of inflation. In the 1970s, US money supply grew at
an average annual rate of 9.6%, the highest rate in the previous half-century; inflation
averaged 7.4%, also a half-century high. In the 1990s, annual monetary growth averaged
only 3.9%, and the average inflation rate was just 2.9%.
That is why the absence of any inflationary response to the Feds massive bond
purchases in the past five years seems so puzzling. But the puzzle disappears when we
recognize that quantitative easing is not the same thing as printing money or, more
accurately, increasing the stock of money.
The stock of money that relates most closely to inflation consists primarily of the deposits
that businesses and households have at commercial banks. Traditionally, greater
amounts of Fed bond buying have led to faster growth of this money stock. But a
fundamental change in the Feds rules in 2008 broke the link between its bond buying
and the subsequent size of the money stock. As a result, the Fed has bought a massive
amount of bonds without causing the stock of money and thus the rate of inflation to
rise.
The link between bond purchases and the money stock depends on the role of
commercial banks excess reserves. When the Fed buys Treasury bonds or other assets
like mortgage-backed securities, it creates reserves for the commercial banks, which the
banks deposit at the Fed itself.

Commercial banks are required to hold reserves equal to a share of their checkable
deposits. Since reserves in excess of the required amount did not earn any interest from
the Fed before 2008, commercial banks had an incentive to lend to households and
businesses until the resulting growth of deposits used up all of those excess reserves.
Those increased deposits at commercial banks were, by definition, an increase in the
relevant stock of money.
An increase in bank loans allows households and businesses to increase their spending.
That extra spending means a higher level of nominal GDP (output at market prices).
Some of the increase in nominal GDP takes the form of higher real (inflation-adjusted)
GDP, while the rest shows up as inflation. That is how Fed bond purchases have
historically increased the stock of money and the rate of inflation.
The link between Fed bond purchases and the subsequent growth of the money stock
changed after 2008, because the Fed began to pay interest on excess reserves. The
interest rate on these totally safe and liquid deposits induced the banks to maintain
excess reserves at the Fed instead of lending and creating deposits to absorb the
increased reserves, as they would have done before 2008.
As a result, the volume of excess reserves held at the Fed increased dramatically from
less than $2 billion in 2008 to $1.8 trillion now. But the new Fed policy of paying interest
on excess reserves meant that this increased availability of excess reserves did not lead
after 2008 to much faster deposit growth and a much larger stock of money.
The size of the broad money stock (known as M2) grew at an average rate of just 6.2% a
year from the end of 2008 to the end of 2012. While nominal GDP generally rises over
long periods of time at the same rate as the money stock, with interest rates very low and
declining, households and institutions were willing to hold more money relative to total
nominal GDP after 2008. So, while M2 grew by more than 6%, nominal GDP grew by just
3.5% and the GDP price index rose by only 1.7%.
So it is not surprising that inflation has remained so moderate indeed, lower than in any
decade since the end of World War II. And it is also not surprising that quantitative easing
has done so little to increase nominal spending and real economic activity.
The absence of significant inflation in the past few years does not mean that it wont rise
in the future. When businesses and households eventually increase their demand for
loans, commercial banks that have adequate capital can meet that demand with new
lending without running into the limits that might otherwise result from inadequate
reserves. The resulting growth of spending by businesses and households might be
welcome at first, but it could soon become a source of unwanted inflation.
The Fed could, in principle, limit inflationary lending by raising the interest rate on excess
reserves or by using open-market operations to increase the short-term federal funds
interest rate. But the Fed may hesitate to act, or may act with insufficient force, owing to
its dual mandate to focus on employment as well as price stability.
That outcome is more likely if high rates of long-term unemployment and
underemployment persist even as the inflation rate rises. And that is why investors are

right to worry that inflation could return, even if the Feds massive bond purchases in
recent years have not brought it about.

FEB 28, 2013

Two Dollar Fallacies

CAMBRIDGE The United States current fiscal and monetary policies are
unsustainable. The US governments net debt as a share of GDP has doubled in the past
five years, and the ratio is projected to be higher a decade from now, even if the economy
has fully recovered and interest rates are in a normal range. An aging US population will
cause social benefits to rise rapidly, pushing the debt to more than 100% of GDP and
accelerating its rate of increase. Although the Federal Reserve and foreign creditors like
China are now financing the increase, their willingness to do so is not unlimited.
Likewise, the Feds policy of large-scale asset purchases has increased commercial
banks excess reserves to unprecedented levels (approaching $2 trillion), and has driven
the real interest rate on ten-year Treasury bonds to an unprecedented negative level. As
the Fed acknowledges, this will have to stop and be reversed.
While the future evolution of these imbalances remains unclear, the result could
eventually be a sharp rise in long-term interest rates and a substantial fall in the dollars
value, driven mainly by foreign investors reluctance to continue expanding their holdings
of US debt. American investors, fearing an unwinding of the fiscal and monetary
positions, might contribute to these changes by seeking to shift their portfolios to assets
of other countries.
While I share these concerns, others frequently rely on two key arguments to dismiss the
fear of a run on the dollar: the dollar is a reserve currency, and it carries fewer risks than
other currencies. Neither argument is persuasive.
Consider first the claim that the dollars status as a reserve currency protects it, because
governments around the world need to hold dollars as foreign exchange reserves. The
problem is that foreign holdings of dollar securities are no longer primarily foreign
exchange reserves in the traditional sense.
In earlier decades, countries held dollars because they needed to have a highly liquid and
widely accepted currency to bridge the financing gap if their imports exceeded their
exports. The obvious candidate for this reserve fund was US Treasury bills.
But, since the late 1990s, countries like South Korea, Taiwan, and Singapore have
accumulated very large volumes of foreign reserves, reflecting both export-driven growth
strategies and a desire to avoid a repeat of the speculative currency attacks that triggered
the 1997-1998 Asian financial crisis. With each of these countries holding more than $200
billion in foreign-exchange holdings and China holding more than $3 trillion these are
no longer funds intended to bridge trade-balance shortfalls. They are major national
assets that must be invested with attention to yield and risk.
So, although dollar bonds and, increasingly, dollar equities are a large part of these
countries sovereign wealth accounts, most of the dollar securities that they hold are not
needed to finance trade imbalances. Even if these countries want to continue to hold a

minimum core of their portfolios in a form that can be used in the traditional foreignexchange role, most of their portfolios will respond to their perception of different
currencies risks.
In short, the US no longer has what Valry Giscard dEstaing, as Frances finance
minister in the 1960s, accurately called the exorbitant privilege that stemmed from
having a reserve currency as its legal tender.
But some argue that, even if the dollar is not protected by being a reserve currency, it is
still safer than other currencies. If investors dont want to hold euros, pounds, or yen,
where else can they go?
That argument is also false. Large portfolio investors dont put all of their funds in a single
currency. They diversify their funds among different currencies and different types of
financial assets. If they perceive that the dollar and dollar bonds have become riskier,
they will want to change the distribution of assets in their portfolios. So, even if the dollar
is still regarded as the safest of assets, the demand for dollars will decline if its relative
safety is seen to have declined.
When that happens, exchange rates and interest rates can change without assets being
sold and new assets bought. If foreign holders of dollar bonds become concerned that the
unsustainability of Americas situation will lead to higher interest rates and a weaker
dollar, they will want to sell dollar bonds. If that feeling is widespread, the value of the
dollar and the price of dollar bonds can both decline without any net change in the holding
of these assets.
The dollars real trade-weighted value already is more than 25% lower than it was a
decade ago, notwithstanding the problems in Europe and in other countries. And, despite
a more competitive exchange rate, the US continues to run a large current-account
deficit. If progress is not made in reducing the projected fiscal imbalances and limiting the
growth of bank reserves, reduced demand for dollar assets could cause the dollar to fall
more rapidly and the interest rate on dollar securities to rise.

APR 29, 2013

Chinas New Path

CAMBRIDGE The opaque nature of Chinas government makes it difficult to see where
Chinese economic policy is heading, and thus how the Chinese economy will develop in the
years ahead. But the scale of Chinas economy and its role in global trade and financial
markets compel us to try to understand the intentions of Chinas new leadership.
A useful starting point is to examine the key appointments that have been made since
President Xi Jinping assumed office. One surprise was the decision to retain Zhou Xiaochuan
as Governor of the Peoples Bank of China (PBOC). Zhou had come to the end of his term
and had reached an age at which officials are supposed to retire. So the decision to keep him
on for at least the next two years represents a significant endorsement by the new Chinese
leadership.
Zhou is an intelligent and internationally respected expert on monetary policy and finance. As
the head of the PBOC, he has favored more market-based monetary policies and increased

internationalization of Chinas currency, the renminbi. He has also worked successfully to

contain inflationary pressures. We can expect more of the same in the coming years.
The new finance minister, Lou Jiwei, comes to the ministry from the China Investment
Corporation, Chinas sovereign wealth fund, where he dealt with global capital markets on a
daily basis. Lou, a trained economist who previously served in the Ministry of Finance as a
deputy minister, where he was a voice for pro-market reforms, indicated his current approach
to tax and budget policy at a recent meeting in Beijing. He rejected what he described as the
European style of very large government and high tax rates and the American style of lower
tax rates but large fiscal deficits, in favor of low budget deficits and a tax system that would
promote opportunities for individuals and private enterprises.
Xi and Premier Li Keqiang obviously knew what they were getting when they appointed Lou.
And, despite his age, they promised that he would have a full five years as Finance Minister,
which would push his tenure past the normal retirement age.
Liu He is perhaps the least visible of the key economic thinkers. Liu played an important role
in shaping the recently adopted 12th Five-Year Plan, with its emphasis on urbanization and
service-sector development as a means to increase personal incomes and the share of
consumer spending in GDP. He has recently been promoted to the post of Deputy Director of
the National Development and Reform Commission, the principal body that advises the State
Council on economic-development strategy and macroeconomic policy.
Taken together, these appointments demonstrate the new Chinese leaderships emphasis on
pro-market reforms and a shift from heavy industry to greater reliance on consumption and
services. That shift is likely to mean a slower rate of GDP growth than the annual rate of
nearly 10% that China achieved during the last three decades. But a slowdown to 7% annual
growth would still double Chinas GDP over the next decade.
More consumption and less heavy industry will also reduce Chinas demand for raw materials,
dampening global commodity prices. Even more significant, shifting income from state-owned
enterprises to middle-class workers and increasing consumer spending will reduce Chinas
enormous saving rate. Since a countrys current-account surplus is the difference between its
national saving and its national investment, Chinas current-account surplus is likely to
continue to shrink in the coming years. That is consistent with the Five-Year Plans goal of
basing GDP growth more on domestic demand and less on exports.
Since Chinas external surplus is already down to less than 2% of GDP, a decline in domestic
saving could result in China beginning to run a current-account deficit. In that case, China
would no longer be a net buyer of foreign bonds and other assets. If China wanted to continue
to invest in foreign businesses and natural resources, it would have to become a net seller of
bonds from its portfolio.
The new leadership will, of course, face serious obstacles as it tries to shift policy in these
market-friendly directions. Chinas state-owned enterprises are powerful forces in the
economy, with substantial political influence; they will resist the shift from heavy industry to
services.
Likewise, the widespread and official recognition of corruption introduces a new source of
uncertainty into national and local politics. But Chinas new leaders have signaled where they
want the economy to go and have emphasized their determination to reduce corruption. Most

important, they have put talented people in charge of the process. The rest of the world
should hope that they succeed.

JAN 28, 2011

The End of Chinas Surplus

CAMBRIDGE Chinas current-account surplus the combination of its trade surplus and its
net income from foreign investments is the largest in the world. With a trade surplus of $190
billion and the income from its nearly $3 trillion portfolio of foreign assets, Chinas external
surplus stands at $316 billion, or 6.1% of annual GDP.
Because the current-account surplus is denominated in foreign currencies, China must use
these funds to invest abroad, primarily by purchasing government bonds issued by the United
States and European countries. As a result, interest rates in those countries are lower than
they would otherwise be.
That may all be about to change. The policies that China will adopt as part of its new five-year
plan will shrink its trade and current-account surpluses. It is possible that, before the end of
the decade, Chinas current-account surplus will move into deficit, as the country imports
more than it exports and spends its foreign-investment income on imports rather than on
foreign securities. If that happens, China will no longer be a net buyer of US and other foreign
bonds, putting upward pressure on interest rates in those countries.
Although this scenario might now seem implausible, it is actually quite likely to occur. After all,
the policies that China will implement in the next few years target the countrys enormous
saving rate the cause of its large current-account surplus.
In any country, the current-account balance is the difference between national saving and
national investment in plant and equipment, housing, and inventories. This key fact is not a
matter of economic theory or an historic regularity. It is a fundamental national-income
accounting identity that must hold for every country in every year. So any country that reduces
its saving without cutting its investment will see its current-account surplus decline.
Chinas national saving rate including household saving and business saving is now about
45% of its GDP, which is the highest rate in the world. But, looking ahead, the five-year plan
will cause the saving rate to decline, as China seeks to increase consumer spending and
therefore the standard of living of the average Chinese.
The plan calls for a shift to higher real wages so that household income will rise as a share of
GDP. Moreover, state-owned enterprises will be required to pay out a larger portion of their
earnings as dividends. And the government will increase its spending on consumption
services like health care, education, and housing.
These policies are motivated by domestic considerations, as the Chinese government seeks
to raise living standards more rapidly than the moderating growth rate of GDP. Their net effect
will be to raise consumption as a share of GDP and to reduce the national saving rate. And
with that lower saving rate will come a smaller current-account surplus.
Since Chinas current-account surplus is now 6% of its GDP, if the saving rate declines from
the current 45% to less than 39% still higher than any other country the surplus will
become a deficit.

This outlook for the current-account balance does not depend on what happens to the
renminbis exchange rate against other currencies. The saving-investment imbalance is
fundamental, and it alone determines a countrys external position.
But the fall in domestic saving is likely to cause the Chinese government to allow the renminbi
to appreciate more rapidly. Higher domestic consumer spending would otherwise create
inflationary pressures. Allowing the currency to appreciate will help to offset those pressures
and restrain price growth.
A stronger renminbi would reduce the import bill, including prices for oil and other production
inputs, while making Chinese goods more expensive for foreign buyers and foreign goods
more attractive to Chinese consumers. This would cause a shift from exports to production for
the domestic market, thereby shrinking the trade surplus, in addition to curbing inflation.
Chinas trade surplus and the renminbis exchange rate were high on the list of topics that
President Hu Jintao and US President Barack Obama discussed when Hu visited Washington
earlier this month. The Americans are eager for China to reduce its surplus and allow its
currency to appreciate more rapidly. But they should be careful what they wish for, because a
lower surplus and a stronger renminbi imply a day when China is no longer a net buyer of US
government bonds. The US should start planning for that day now.

MAR 29, 2011

Chinas Five-Year Plan and Global Interest

Rates
CAMBRIDGE Chinas new five-year plan will have important implications for the global
economy. Its key feature is to shift official policy from maximizing GDP growth toward raising
consumption and average workers standard of living. Although this change is driven by
Chinese domestic considerations, it could have a significant impact on global capital flows
and interest rates.
Chinas high rate of GDP growth over the past decade has, of course, raised the real incomes
of hundreds of millions of Chinese, particularly those living in or near urban areas. And the
funds that urban workers send to relatives who remain in the agricultural sector have helped
to raise their standard of living as well.
But real wages and consumption have grown more slowly than Chinas total GDP. Much of the
income from GDP growth went to large state-owned enterprises, which strengthened their
monopoly power. And a substantial share of Chinas output goes abroad, with exports
exceeding imports by enough to create a current-account surplus of more than $350 billion
over the past year.
China now plans to raise the relative growth rate of real wages and to encourage increased
consumer spending. There will also be more emphasis on expanding service industries and
less on manufacturing. State-owned enterprises will be forced to distribute more of their
profits. The rising value of the renminbi will induce Chinese manufacturers to shift their
emphasis from export markets to production for markets at home. And the government will
spend more on low-income housing and to expand health-care services.

All of this will mean a reduction in national saving and an increase in spending by households
and the Chinese government. China now has the worlds highest saving rate, probably close
to 50% of its GDP, which is important both at home and globally, because it drives the
countrys current-account surplus.
A country that saves more than it invests in equipment and structures (as China does) has the
extra output to send abroad as a current-account surplus, while a country that invests more
than it saves (as the United States does) must fill the gap by importing more from the rest of
the world than it exports. And a country with a current-account surplus has the funds to lend
and invest in the rest of the world, while a country with a current-account deficit must finance
its external gap by borrowing from the rest of the world. More precisely, a countrys currentaccount balance is exactly equal to the difference between its national saving and its
investment.
The future reduction in Chinas saving will therefore mean a reduction in Chinas currentaccount surplus and thus in its ability to lend to the US and other countries. If the new
emphasis on increased consumption shrank Chinas saving rate by 5% of its GDP, it would
still have the worlds highest saving rate. But a five-percentage-point fall would completely
eliminate Chinas current-account surplus. That may not happen, but it certainly could happen
by the end of the five-year plan.
If it does, the impact on the global capital market would be enormous. With no currentaccount surplus, China would no longer be a net purchaser of US government bonds and
other foreign securities. Moreover, if the Chinese government and Chinese firms want to
continue investing in overseas oil resources and in foreign businesses, China will have to sell
dollar bonds or other sovereign debt from its portfolio. The net result would be higher interest
rates on US and other bonds around the world.
Whether interest rates do rise will also depend on how US saving and investment evolves
over the same period. Americas household saving rate has risen since 2007 by about 3% of
GDP. Corporate saving is also up. But the surge in the government deficit has absorbed all of
that extra saving and more.
Indeed, the only reason that Americas current-account deficit was lower in 2010 than in
previous years is that investment in housing and other construction declined sharply. If
Americans demand for housing picks up and businesses want to increase their investment, a
clash between Chinas lower saving rate and a continued high fiscal deficit in the US could
drive up global interest rates significantly.