BEING A CHINA BULL – NOTHING WRONG WITH A BIT OF FINANCIAL REPRESSION

 

Financial repression is an important idea in the modern policy context. It denotes an environment where interest rates are artifically low with the intention of helping one or more sectors of the economy, at the expense of another. The idea comes up a lot inMichael Pettis’ work and is behind two parts in his first question:

…which sector of the economy will pay for the excess, and what is the mechanism that will ensure the necessary wealth transfer?

This post seeks to answer these questions.

Financial repression

Financial repression, of course, disrupts the natural equilibrium of markets. It forces costs on one part of the economy at the expense of another.

This would imply that financial repression is a zero-sum exercise. I am not convinced. It will most often depend on the utility curves of agents in the economy: give people the right incentives and it could be positive(that is the policy makers’ intent).

Michael’s argument goes that China’s SOEs are investing aggressively with captive funds from the nation’s households.

Jobs are protected at the SOEs and strong returns generated for the owners, the Chinese state. Households, however, suffer through an often negative real return on their savings.

The United States

Financial repression has been a staple of United States policy in the aftermath of the 2008/09 financial crisis. Zero Interest Rate Policy (ZIRP) is financial repression in its purest form.

The winners and losers in the US are relatively clear. Low rates help two broad groups: households with mortgages and banks.

ZIRP has meaningfully lowered long-term mortgage rates in the United States from 5.5% to around 3.5% since rates reached 0 in 2009. Banks have benefited through better asset quality though credit growth has been weak.

In turn, however, repression has negatively impacted savers and all households who have paid more for globally traded commodities as a result of the weakened US$.

I would argue the impacts of both negative real rates and higher commodity prices have had an out-sized impact on the poor while the rich have been relatively protected.

Indeed, if there is a particular culprit for rising income and wealth inequality in the US I would argue it is ZIRP.

For instance, each 100bps of interest rates payable on money market funds is equivalent to $40 billion a year. Equally, since 2009 gas prices have risen 130% in the US but equivalent petrol prices are up just 40% in Australia.

The best protection against negative real returns in savings and rising prices in some areas has been equities.

Equity outperformance since 2009 has been substantial. It has reflected a fall in the discout rate that has boosted asset prices, rising profitability through cost control (equities have been a small hedge against unemployment) and the pricing power of companies able to pass on global commodity price rises.

The problem from an equality perspective is that equity ownership is concentrated in high income groups. Data from the US census bureau shows equity ownership is determined by income with the highest earning households being most likely to own equities. 

This is not surprising. Higher income households are able to take more risk with their wealth. The chart implies that high income households are much better protected from repression both through their savings and the net impact of price rises.

China

The case for financial repression as a negative for China is, in my opinion, much less strong. Indeed, I would argue it is largely positive from an equality perspective.

Yes, savers are hurt. But the savers are the SOEs or concentrated in China’s small number of middle class households. For the SOEs, the balance of low rates for savings is cheap credit.

For middle class households, the effect is non-negligible but the number of households affected is relatively small, the Carnegie Endowment estimates China’s middle class stands at 100-120 million households.

But what about the credit side of the ledger. From a profit perspective there’s little evidence that Chinese companies are making outsized gains.

Indeed, the latest profit data from listed companies in China show profit margins at around 5% in aggregate and negative profit margins in at least one sector. 

Similarly, SOEs find things tough.For example, State Grid makes a 2.5% return on its asset base. This fits with my view that it is hard to make money in China, and deliberately so.

So who’s benefiting from financial repression? Labour, that’s who. Wages growth in China is strong, as it has been for some time.

This is particularly the case when compared to BRIC comparators where wage growth has been much slower.

This suggests to me that the biggest beneficiary of financial repression is the household sector, particularly those in central and western regions. The cheap funding of SOEs has led to substantial investment in productive capacity.

While this has negatively impacted the profitability of the SOEs it has also led to a real increase in the household sector’s share of the economy. Only the official government sector through tax revenue has done better, as I will discuss later.

A small but useful example of the importance of SOE investment in raising productivity is the composition of wage growth in China. Currently, wages are relatively flat in Shanghai and other coastal areas.

The growth is in inland areas, suggesting infrastructure investment is making a real difference in labour productivity and so wage growth.

Conclusion

Financial repression is a matter of perspective and balance. It is pursued by policy-makers with, probably, good intentions but often results in ill-effects. It is not difficult to make the case that financial repression in the US has led to a considerable increase in inequality.

But I have come to the conclusion that in China financial repression, pursued through low interest rates, is having a positive effect on raising wages and acting as a brake on inequality.

The SOEs, through low profits, and the middle class, through low returns on capital, are paying for a broad-based rise in productivity and wages spurred by investment.

 

JAMES WHITE is an economist, trying to make sense of a world of abundance. A big believer in China and its growth path. Participant in Australia’s economy. Commentator on US and Europe, because I want to! Nothing contained anywhere on this site constitutes or should be construed as investing or financial advice, suggestion, or recommendation. Please consult a financial professional and do due diligence before engaging in any purchase or sale of securities and other assets. While we ensure the information provided here are reliable, we do not represent it as accurate or complete, and should not be relied on as such.

 

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