China's Current Account, Rebalancing, & U.S. Interest Rates

This post draws significantly on M. Pettis.

The argument: If China's consumption (as a % of GDP) rises faster than investment declines, this will reduce China's current account surplus (decline in savings); and thus a reduction in the capital it exports. This means China recycles less of the worlds (and history's) largest surplus, it purchases less US treasuries which causes U.S. interest rates to rise.

Martin Feldstein wrote: "...change driven by Chinese domestic considerations, it could have significant impact on capital flows and interest rates."

As China re-balances, the savings rates will contract as a % of GDP. This will shrink the current account unless investment grows more slowly than savings, which is unlikely because a sharp reduction in investment would force a collapse in top line GDP. (Note - this means China will keep investment high to reduce impact of a slowdown AND will extend the period of slowdown in China once it happens).

The point that is wrong here is that a contracting surplus and less capital exports means higher interest rates. Conversely an expanding surplus and higher capital exports don't mean lower U.S. interest rates, though this did happen from 2004-2008. Rather, its the way in which the surplus expands or declines that will have a high affect on U.S. interest rates.

If the U.S. current account deficit rises due to surge in U.S. investment, than higher capital imports will not affect interest rates, because the supply of savings will be met by demand of savings. In fact, if the investment brings jobs, the increase income would lead to consumption and interest rates could rise.

If the current account deficit rises because of a reduction in net foreign consumption, then the drop in global demand for labor will create unemployment, growth drops, and either the government increases deficits to offset the decline or the fed encourages a surge in consumer financing - either way debt levels surge. Depending on the size of deficit or consumer financing, rates could do anything. More likely, they fall because of the weak growth and unemployment

In other words, interest rates don't fall because the U.S. is lucky enough to have foreigners lending them money.

Conversely - if China's current account deficit declines by recycling the surplus onto another country - Brazil for example - by stockpiling commodities, then the US current account is unchanged and the capital is imported from Brazil.

Lastly, if China's current account surplus is collapsed by a surge in Chinese consumption, then the U.S. deficit will decline. In that case, China would export less capital as Martin Feldstein explained. But a decline in the U.S. deficit would be expansionary, so less government bonds (or private borrowing) would be issued. In this instance, its not obvious that rates would rise or fall, though they would be responding to higher and the fiscal and monetary responses to growth.

Warnings about what happens if China stops buying government bonds are no different than warnings about what might happen when the U.S. closes its trade deficit. It all depends - if the deficit contracts because investment drops faster than savings that will be bad, and if Chinese consumers import more goods from the U.S. that will be good, regardless of the interest rates.