Monday, September 14, 2009

Can China Benefit if the U.S. Consumes Less?

By Scott Tolep

Without question, the U.S. and Chinese economies are interdependent and each nation has a vested economic interest in the other. The U.S. and China have one of the most significant trading partnerships in the world, with over $400 billion of trade in 2008. They are each other's largest or second largest trading partners, and China owns more U.S. Treasury debt (about $800 billion) than any other country.

The global economic recession has forced U.S. households to reduce debt and consumption levels. After 15 years in which Americans have saved less than 5% of their disposable income (at times, appreciably less so), the U.S. is finally beginning to save more. This trend may continue even after the U.S. economy resumes GDP growth, if unemployment remains above, and income growth remains below, historical levels- a realistic scenario by many economists' accounts.

So, with exports to the U.S. accounting for 10% of China's economy, is it possible that a prolonged increase in U.S. savings could actually benefit China? It is possible if it triggers the economic reforms necessary to unlock the potential of its huge domestic consumer market. China's current consumption rate is 35% of GDP, which is the lowest rate of any major economy in the world, despite China being the world's third largest economy. China's economic growth rate, the highest among G-20 nations, cannot be sustained given the current lack of domestic consumption.

China must gradually allow the yuan to float against the dollar. This would not only boost households' real spending power and lift private consumption demand, but it would also allow China to conduct independent monetary policy, making it less susceptible to asset-price bubbles. It would also strengthen China's relations with the western world by warding off protectionist voices in the U.S. and other countries.

In 2007, the IMF pointed out that household incomes fell steadily in China between 1992-2004, and this caused a steady decrease in consumption. During this period, state-run banks and enterprises gained a disproportionate share of China's income and wealth. For consumers to spend more, this has to change. China must create a stronger social safety net for its citizens, and provide them with a more open financial system, one that provides them with greater investment opportunity.

China's reluctance to pursue aggressively economic reform may be linked to underlying political motivations. The centralized government may simply be seeking to delay potentially destabilizing changes. Making the necessary adjustments today may cause short-term disruptions in China, but waiting for the inevitable day of reckoning will almost certainly render the long-term consequences immeasurably worse. Fortunately for China, it may not have to wait too much long as U.S. consumers keep their wallets sealed.