The Cost of Low Interest Rates

This post draws heavily on M. Pettis.

What is the cost of the transfer of wealth from households and savers to banks?

Over the past decade nominal lending rates in China have been about 6% while nominal GDP growth rates have been 14%. Economic theory tells us that nominal interest rates should be equal to nominal GDP growth rates if providers of capital are to earn their fair share of growth, and in fact in developed countries the relationship holds pretty well. (Appendix 1 - the case for and against nominal interest rates equal to nominal GDP).

Assuming IR are 75% of nominal GDP, then China's 14% average growth rate means nominal IR should be 10.5%, versus the actual 6% lending rate. This means interest rates are at between 350 and 800 basis points too low. If we add the excess bank spread (estimated at between 150 and 250 bps) we can say that at the very low end, nominal IR are 500 basis points too low.

That means that 5% of GDP is transferred from Households to Businesses every year. Lets show some numbers for context.

In 2009, total bank deposits in China were RMB64 tr; 60% of those deposits belong to households (rough guesstimate); RMB64 tr * 60% * 5% = RMB 1.9 tr. That represents 5% of GDP.

Of course, households are not only paying to subsidize banks, they pay to subsidize manufacturing investments, real estate investments, infrastructure investment, sterilization bills, PBOC borrowing - investments that have negative NPVs without the subsidy. (Capital misallocation).

Even if banks are insolvent, China can protect itself from illiquidity because the government controls funding and interest rates. In the past, China could grow its way out, despite declining relative consumption (and a rising savings rate and rising trade balance), because of the growing world economy. As long as debt levels in deficit countries could rise to counteract adverse unemployment effects the world (US) has no problem absorbing the trade surpluses.

Things are different now
Unemployment is high in deficit countries. Debt levels are being forced down. China must reduce its dependence on trade and investment by increasing the share of household consumption. Household consumption is dependent on household income, so as/if household income is taxed away by banking costs - it will be impossible for household consumption to surge.

The result is for total GDP to drop sufficiently where household consumption takes on a larger share. Japan is the example of this, where consumption growth declined to 1-2% annually as households were forced to subsidize insolvent institutions through repressed interest rates and undervalued currency. In Japan's case, total economic growth has been less than consumption growth as China rebalances its economy.




Appendix 1
Against - historically, developing countries have not had nominal interest rates equal to nominal GDP. When IR < Nominal GDP, then providers capital get less than their share of growth. In China, households are providers of capital, businesses & govenment are users of capital (they use it for FGF) = transfer of wealth. (Note, is the savings rate an independent variable that forces down interest rates; or is the savings rate a consequence of low interest rates and other policies that "tax" households and "subsidize" production - Think of it this way - policies that tax households and subsidize production forces more production than consumption, which forces up the savings rate).

For - the "sample" of developing countries have closed or sticky capital accounts - which are used to repress currency value to protect trade; these countries also systematically repress interest rates.
On average, nominal IR are 75% of nominal GDP with wide dispersion around the mean.