More on China's macroeconomic imbalances

Much has been written about China's economic policies that sought to boost exports at the cost of everything else. It is now very clear that it has come with significant costs and serious external and internal macroeconomic imbalances. Externally, Beijing has aggressively intervened in the market to keep the renminbi undervalued. Internally, it has kept interest rates artificially low which in turn has resulted in severe financial repression and suppressed domestic private consumption.

Economix has an interview with Nicholas Lardy who outlines why these two imbalances, external and internal, are closely linked,

The government adopted a low-interest-rate policy at that time. Deposit rates were held down so that the after-inflation return on bank deposits for savers turned negative. That reduced household income below the path it otherwise would have achieved, leading to a slowdown in the rate of growth of household consumption expenditure. Since most households lack adequate health insurance and retirement programs, they also responded to lower deposit rates by saving even more, so as not to be delayed in reaching their savings goals. That put further downward pressure on private consumption expenditure.

China has adopted a low-interest-rate policy as a mechanism to reduce the costs of simultaneously maintaining price stability and an undervalued exchange rate. The central bank intervened massively in the foreign exchange market to moderate the pace of appreciation of the renminbi, China’s currency. And that intervention led to a large, ongoing increase in the domestic money supply, which the central bank had to offset by the sale of central bank bills and requiring banks to increase their reserves deposited at the central bank. The central bank had to pay interest on these bills and reserves, and the low-interest-rate policy made the cost of these operations less than it would have been had interest rates been market determined.

One could add several other consequences of the low interest rate policy. While it has been a major contributor to the promotion of China's investment driven economic growth strategy, it has also generated distortions in resource allocation, the most prominent and of greatest concern being the real estate bubble.

Stripped off all its macroeconomics, China's investment and export based economic growth strategy has been underpinned by massive government inflated bubbles, in multiple sectors. And for much more than a decade now, the country has managed to successfully carry on the strategy. The government kept interest rate and exchange rate suppressed so as to boost investment and exports. Coupled with capital controls, low interest rates, boosted the coffers of the country's public sector banks with cheap capital, which they on-lend to businesses at low rates. Real estate market boomed, which amplified the finances of state entities and local governments which owned all the land. These agencies leveraged the high real estate values to raise resources to finance their massive infrastructure investments. On the external side, the low exchange rate raised export competitiveness, which in turn encouraged massive inflows of foreign direct investment. A sustained period of widespread global economic growth provided all the favorable conditions for China to pursue this export strategy uninterrupted.

There are several dangers associated with this strategy. Lardy himself points to one such transmission channel,

Urban households have piled into property investment in part because of negative real interest rates on bank deposits, and capital controls that prevent most households from investing abroad. The property boom is based on the widespread assumption that property prices will continue to move upward with only brief and shallow price corrections. If this expectation changes, investment demand in residential property could evaporate. Demand for output of steel, cement, copper, aluminum and many other products is driven largely by residential real estate, so if that sector slumps it could usher in a long period of much slower economic growth.

While the rulers in Beijing certainly deserve their share of compliments for the country's spectacular economic growth, it cannot be denied that China has enjoyed more than its fair share of luck and benefited from favorable external circumstances. Now that the consequences of the imbalances, especially the internal ones, are becoming ever more apparent, Beijing ins being forced to re-evaluate its options. Low interest rates are becoming unsustainable for a variety of reasons, making over-reliance on the investment-driven growth strategy unsustainable. Propsects of anemic economic conditions in much of developed world for the foreseeable future puts question marks on the export-led growth approach.

In the circumstances, re-balancing will have to involve nudging the Chinese consumers to play a more central role. This will require rewarding and incentivizing them with higher interest rates and more diversified and remunerative investment alternatives for their savings (read greater financial liberalization). Further, manufacturing wages will have to become more market determined, so that people's purchasing power increases proportionately with the economy's growth. Both these will have to be accompanied by domestic policies that establish a comprehensive social safety net and enabling greater access to affordable urban housing, tertiary education, and so on.

The last-mile challenge in banking for the poor

It has always been thought that lack of access to formal bank accounts prevented poor people from saving more and once accounts were opened they would be able to more optimally manage their finances. But now that we have made some progress, albeit tiny (only 5.5% of 650,000 Indian villages have bank branches and half the adults in the country do not have access to bank accounts), with access through the campaign for total financial inclusion (TFI), have the desired outcomes been achieved for those people?

Surprisingly, it does appear that having a bank account does not automatically translate into its use, much less efficient management of personal finances. Livemint points to a study by Skoch Development Foundation which found that only 11% of 25.1 million no-frills accounts opened between April 2007 and May 2009 are operational mostly because of the high costs.

India Development Blog points to an IFMR study of the impact of TFI campaign in Gulbarga District of Karnataka (claimed to have achieved 100% financial inclusion), which found that 36% of sample households remained without access to formal and semi-formal savings mechanisms and more importantly, access to bank accounts did not translate into bank account usage. It was found that the accounts were used mostly to manage NREGS payments or SHG transactions. Critical to the lesser than expected account usage is the high transaction costs, especially by way of travel costs.

I am inclined to believe that even if access to formal banking systems, by way of opening a bank account, is increased, actual usage is likely to remain low unless bridge the last mile gap and take banking to the door-step of the people, especially in rural areas. The recent decision by the Reserve Bank of India to approve the deployment of mobile bank business correspondents, equipped with electronic terminals, to transact at the sub-branch level is certain to increase the quality of access. This will ensure that, unlike now, rural account holders are more likely to actively transact using their accounts.   

In this context, mobile phones have the potential to revolutionize banking and increase utilization dramatically. Mobile phones-based technologies offer the attraction of directly placing the bank account in the hands of the customer, thereby lowering transaction costs and increasing the likelihood of account usage. It may therefore be tempting to get carried away by this possibility, coupled with a campaign to increase financial literacy, and assume that it will ensure account usage.

However, dovetailing NREGS and other government cash transfers through TFI accounts, extensive use of business correspondents and mobile phone-bassed technologies, and financial literacy, while necessary are not sufficient conditions to ensure optimal account usage.In fact, unless complemented with other initiatives, mere increase in access to banking accounts, could be counter-productive. It could just as easily enable access to debt and other less than desirable financial products, whose extensive adoption could be detrimental to the interests of the poor people.

Behavioural science teaches us that even with access to their accounts and adequate financial literacy, human beings are cognitively constrained. This in turn means that despite firm commitment to save or spend on certain things, people tend to renege and fall short on achievement. People discount the value of later rewards by a factor that increases with the length of the delay. They are therefore tempted to spend on immediate needs as opposed to save for important long-term requirements. Further, drawing from theories of "mental accounting", it has also been found that people tend to save optimally when they they know what they are saving for.  

It is therefore necessary that the bank accounts are structured to address these cognitive biases. This assumes importance since we need to bear in mind that the ultimate objective is not to merely enable access to bank account, but to enable poor people with systems to more effectively manage their scarce finances. What can be done to ensure that poor people save more, optimize on their interest returns, manage their long-term needs like health care, children's education and pensions, make more effective purchase decisions, and so on? In simple terms, how do we ensure that people not only manage their finances effectively, but also overcome their cognitive urges which are often determental to their interests?

I have written about several examples of how innovative financial products can overcome such cognitive biases and increase the likelihood of optimal outcomes for poor people with management of their finances. In fact, bank savings accounts and financial products, with subtle commitment features, have the potential to dramatically increase not only usage but also effective usage of bank accounts. I have bloggged earlier about Save More Tomorrow, default pension savings, lottery savings products, products to increase fertilizer consumption, multi-tier accounts (also here), and budgeting family expenditures. See also this and this.

In this context, there is a big window of opportunity. Bill and Melinda Gates Foundation have just pledged $500 million to helping poor people learn to save money. They propose to fund research and project interventions in this area to emulate the examples like the hugely successful mobile banking for the poor — via cellphone in Kenya and Bangladesh and smart card in Mexico. Spurred on by the low domestic savings rate, this area has been the focus of considerable interest in the US too. It is appropriate that some part of this be leveraged into experimenting with financial products and structured accounts that help overcome cognitive biases.

It needs to be borne in mind that TFI and optimal utilization of bank accounts by the poor needs to go beyond mere door-step acceess to bank accounts.

The savings rate de-regulation

The decision by the RBI to deregulate bank savings rate in its second quarter monetary policy review is one of the most progressive and efficiency increasing reforms in recent years. All banks are currently mandated to pay an interest of only 4% on savings account deposits.

In one stroke it eliminates one of the last remaining glaring incentive distortions in India's banking sector. With 26% of the total bank deposits (as on June 2011) being in the current and savings bank accounts, banks hitherto benefited hugely from an artificially lower cost of funds.

It is expected to increase depositors’ interest income by around Rs 9000 Cr. The Businessline reports that assuming the savings bank deposit rates of banks rise by 1 percentage point, profits before provisions and taxes will be lower by 9.3 per cent (based on FY-11 profits) if they do not pass on the deposit rate hikes to borrowers.



This decision increases competition, lowers entry barriers, encourages savings, and contributes to strengthening the financial markets and increasing the effectiveness of the monetary policy transmission channels. In simple terms, it is one of the rare policy decisions which aligns incentives of all stakeholders and increases overall efficiency of the system. Here is a summary of its benefits.

1. It will increase competition among banks and thereby increase all round efficiency in the sector. Banks will be forced into raising deposit rates so as to attract depositers and also allocating their lendings into the most profitable avenues.

2. It lowers entry barriers by working to the advantage of smaller banks and newer entrants. They have hitherto suffered from a system where location of branches conferred an unfair first-mover advantage. Now with the freedom to price their depsoit rates, these banks can hope to attract accounts by signalling with more competitive rates. This was evident in the immediate aftermath of the decision, with Yes Bank announcing hiking its deposit rates by 200 basis points.

3. It will force banks into diversifying into other transaction and advisory services which will in turn enhance the breadth of India's financial system. This will be felt with much greater force by the public sector banks who have a higher exposure to low cost savings bank deposits. Hitherto, the ceiling on deposit rates had provided banks with a large easy source of money and comfortable assured profits from it (SBI alone loses Rs 1500 Cr for every 50 basis points increase in deposit rates). To this extent, the incentives were not aligned towards getting banks to search for alternative sources of revenues.

4. On the consumers side, given the dominant role of banks in household savings, especially of savings bank accounts in case of the poorer people, this deregulation will enable them to get higher returns on their deposits. This will in turn boost household savings and also encourage people in rural areas to utilize bank accounts to channel and save their incomes. Banks too are certain to come up with more differentiated savings products.

5. It increases the effectiveness of monetary policy transmission mechanisms. As deposit and lending rates are arrived through a competitive process, any changes in the repo rates will, in normal times, is more likely to be transmitted quickly into the financial system and the economy.

China and US - Contrasting paths to structural imbalances?

In many ways, China and US are classic examples of how both free-market capitalism and statist capitalism, through contrasting routes, have produced severe macroeconomic imbalances that have brought the later to its knees and threatens the former. The graphic below insightfully captures the respective problems of the American and Chinese economies.



It was unbridled financial market liberalization and sustained expansionary monetary policy, which fuelled massive property and financial asset bubble and debt-financed household consumption binge, that is the source of much of America's current woes. Notional household income share of the GDP rose on the face of the twin bubbles. Households spent as though there was no tomorrow, running savings down to the bottom. Finally when the bubble burst and the recession took hold, households faced the brunt of the slowdown and even after four years, recovery remains uncertain.

In China, the policies enacted in late nineties, in response to bankruptcy problems facing state-owned companies and banks, looks set to have much the same impact in not the distant future. Beijing assumed tighter control over interest rates and exchange rates, keeping them artificially low to finance cheap loans to businesses and government agencies and increase external competitiveness so as to drive its preferred export-led and infrastructure investment driven economic growth model. This period also coincided with the government abandoning the communist era policies of life-long employment and liberal social safety nets, thereby forcing households to increase their savings to meet educational, health care and housing needs for themselves and their children.

These policies amounted to a huge transfer of wealth from the households to businesses, both government and private, and government agencies. Banks and state-owned companies staged excellent recoveries. But all this was at the cost of households - household consumption, already among the lowest at 45%, fell to just 35%, and savings rate rose sharply to about 40%.



As the Times and the FT point out in two excellent essays, this model worked well so long as the export markets were vibrant and the infrastructure deficit was filled, and the government was able to control the supply and price of credit and thereby keep cost of capital artificially low. As the two primary growth drivers weaken, as is happening now, and the unregulated shadow banking system assumes an increasingly dominant role (it now supplies more credit to the economy than the formal banking system) thereby weakening Beijing's ability to control credit, the sustainability of this growth model becomes doubtful. The sliding property market which financed a major share of the investment spending, especially by local governments, is yet another source of concern.

George Magnus writing in the FT has this to say about China's rebalancing strategy from an investment-centric and credit hungry model to one built around consumption,

"It involves a redistribution of income from capital and profits to labour and wages; radical changes in the role of the exchange rate, interest rates and capital markets; and strategies to counter the high propensity to save by households, corporates and central government. It is also politically divisive because power and economic privilege have to be wrested from party elites, state enterprises and banks, and given to new beneficiaries such as private companies, households, college graduates and rural migrant workers."

It is increasingly inevitable that China can sustain its high growth rates only if its domestic consumers can step into the space being vacated by the traditional growth engines. The question is whether Beijing has the stomach to embrace the required structural reforms to enable this transition?

Incentivizing savings habit among the poor

The government of India have initiated a Total Financial Inclusion (TFI) program to ease formal institutional credit constraints and expand their ability to manage their finances more optimally. However, while the policies under implementation may achieve success with the former, the later remains a much more formidable challenge.



The prevailing set of policies, revolving around the TFI program and door-step banking through business correspondents, will deliver a savings bank account to every citizen. It is also being suggested that the Aadhaar number and Aadhaar-linked savings bank bank accounts could provide the ideal platform to implement the proposed cash transfer schemes to deliver subsidies. All these will still not address the ultimate objective of getting people to optimally utilize their savings bank account to manage their finances efficiently. The challenge will be all the more bigger in promotion of savings among those poor who are more acutely present-biased (or have greater self-control problems).



Promotion of savings habit among the poor has been an area of interesting research in recent years, driven mostly by trends and developments in behavioural economics. Economists like Sendhil Mullainathan have expanded on Richard Thaler's mental accounting framework to explain how people's subliminal predisposition to categorize and evaluate savings and spending decisions can be invoked to nudge people into managing their finances more optimally.



I had blogged earlier about the merits of a system which divides income into separate, end-use based mental accounts.

"It helps people manage their finances more effectively in two ways. One, people are inclined to save if they are aware of what they are saving for. For example, a "car account" is a strong nudge to get people to save for purchasing a car. Two, separation of expenditure heads with pre-defined allocations help in effective management of expenditures."

Based on the mental accounting framework, I have also blogged about the merits of use-directed multi-tier accounts to nudge people into saving for specific purposes.



In this context, the most recent research paper (pdf here) on incentivizing savings among the poor come from an experiment among the rotating savings and credit associations (ROSCAs) of Kenya by Pascaline Dupas and Jonathan Robinson. They provided members of 113 ROSCAs in Kenya with different household and ROSCA savings instruments (like individual lock and key boxes and ROSCA health pot) to save for health and other contingencies and found that it could "substantially increase investment in preventative health, reduce vulnerability to health shocks, and help people meet their savings goals".



They also found that providing people with a designated safe place to keep money was sufficient to overcome the common barriers to savings - transfers to other people and "unplanned expenditures" on temptation goods - through a mental accounting effect ("The money put into the box was seen by respondents as 'for savings' and was therefore less likely to be spent on luxuries or given away to others").



The find strong evidence that use-directed commitment savings products can be effective in promoting savings even among the more present-biased individuals. The ROSCA health pot was a commitment savings approach wherein a sub-group in a ROSCA could agree on a health product and provide additional contribution (over and above their ROSCA contribution), which could be redeemed each month to purchase the particular health product for one member at a time. They write about the present-biased members of the ROSCA,

"The enthusiasm that led them to sign up for the Health Pot tied their hands not only to spend the money a certain way, but also to continue to save on a regular basis (i.e., at each ROSCA meeting). This strong social commitment feature is the only one that enabled present-biased individuals in our sample to overcome their barriers to savings."

They point to an earlier study by the same authors from the same area in Kenya which found that providing simple bank accounts to wmone who run small vending businesses had substantial savings impact only on about 40% of them. They write,

"Since the bank accounts did not provide any form of earmarking or a strong commitment feature, their primary function was likely to provide a designated place to save. The present study suggests that more sophisticated devices that include stronger commitment features might be better suited for some of those individuals who did not use the simple savings account. For others, it appears that a less sophisticated but more easily accessible device such as a Safe Box would be better suited to save small sums on a regular basis."

Paradox of household and corporate savings

Paradox of savings is a fallacy of composition where the perfectly virtuous habit of increasing savings when embraced by everyone generates negative outcomes for the economy as a whole. This is amplified when the economy is facing a recession and aggregate demand is falling. In such circumstances, it is in the interest of the economy if people spend more to shore up the declining aggregate demand.

During the Great Recession, debt-laden households in developed economies, in particular the US, cut back sharply on expenditures and boosted their savings to repay debts.



In response, businesses too have been postponing investments. This coupled with the general trend of businesses to indulge in cost-cutting, mainly through lay-offs, during recessions (so as to, in the main, keep their bottom-lines in tact) means that businesses are sitting on hoards of cash surpluses. At 7% of all their assets, non-financial corporations’ cash and other liquid assets reached $1.9 trillion at the end of 2010, the highest level in the US since 1963.



In the final quarter of 2010, capital expenditures amounted to $975 billion, or 6.6% of gross domestic product — up from a low of 5.4% in 2009 but still well below the 10-year average of about 8%. The non-residential private fixed investments dropped precipitously during the recession.



All this highlights the pro-cyclical nature of their basic economic activities for the two critical stakeholders. When faced with uncertainty, consumers save and businesses postpone investments. In contrast, when the economy is on the up, consumers spend as though there is no tomorrow, while businesses borrow recklessly and over-invest.

Recessions are marked by declines in aggregate demand. Households and businesses shutting-off their spending taps compounds the problem. It is possible, as the East Asian economies and Germany have done on occasions, to export your way out of a downturn. Further, if the recession is not very deep, it is possible to indulge in monetary accommodation and encourage businesses to bring forward investments.

But these were not available options for the US economy at the peak of the Great Recession. Under such circumstances, there is no choice left but for governments to step in and provide a temporary boost to aggregate demand.

The M-PESA success story

It is undoubtedly true that the mobile phone is one of the really revolutionary inventions of our times, with the potential to transform human lifestyles and the way we even do business. Fundamental to its success is its ability to bridge the last-mile connect and deliver numerous services.

I have already blogged about its potential to revolutionize the way people manage their finances. The most famous example of this is the M-PESA - an SMS-based money transfer system that allows individuals to deposit, send, and withdraw funds using their cell phone - that was launched in March 2007 by the Kenyan cell-phone company Safaricom. Today M-PESA reaches approximately 65% of Kenyan households. Similarly, in the Philippines, Globe Telecom operates GCASH, and in South Africa WIZZIT facilitates mobile phone‐based transactions through the formal banking system. An excellent working paper by William Jack and Tavneet Suri documents the rise of M-PESA.

M-PESA is not a banking service. It does not pay interest on deposits nor make loans. It allows users to deposit money into an account stored on their cell phones, to send balances using SMS technology to other users (including sellers of goods and services), and to redeem deposits for regular money. In this sense, M-PESA transfers fungible cellphone talk time.

In exchange for cash deposits, Safaricom issues a commodity known as e-float or e-money, measured in the same units as money, which is held in an account under the user’s name. E-float can be transferred from one customer’s M‐PESA account to another using SMS technology, or sold back to Safaricom in exchange for money. Charges, deducted from users’ accounts, are levied when e-float or e-money is sent, and when cash is withdrawn.

Originally, transfers of e-float sent from one user to another were expected to primarily reflect unrequited remittances, but nowadays, while remittances are still a very important use of M-PESA, e-float transfers are often used to pay directly for goods and services, from electricity bills to taxi-cab fares. To facilitate purchases and sales of e-float, M-PESA maintains and operates an extensive network of over 23,000 agents across Kenya. M-PESA agents hold e-float balances on their own cell-phones, purchased either from Safaricom or from customers, and maintain cash on their premises. They only have to predict the time profile of net e-float needs, and maintain the security of their operations.

M-PESA caters to a specific category of small transactions. The paper finds that the volume of transactions effected between banks under the RTGS (Real Time Gross Settlement] method is nearly 700 times the daily value transacted through M-PESA, and the average mobile transaction is about a hundred times smaller than the average check transaction (Automated Clearing House, or ACH), and even just half the size of the average Automatic Teller Machine (ATM) transaction.

The paper documents many advantagees of mobile phone money transfers. They include facilitation of trade, making it easier for people to pay for, and to receive payment for, goods and services; provide a safe storage mechanism, and thereby increase net household savings; facilitates inter-personal transactions and thereby improve the allocation of savings across households and businesses by deepening the person-to-person credit market; by making transfers across large distances trivially cheap, it improves the investment in, and allocation of, human capital as well as physical capital (say, promote migration); it enhances the ability of individuals to share risk; it enables timely money transfers and thereby provides always-on access to money; empower women, and so on.