Huayu Sun +

Department of Economics, University of International Business and Economics, Beijing, China

Abstract. This paper tracks the official reserves accumulated via trade surplus and finds the official reserves are in excess liquidity in trade deficit countries. The net capital inflow, as the counterpoint of trade deficit, is only a part of original funds supply in deficit countries, not re-injected funds into these countries’ financial markets from external sources. Using consolidated balance sheets of the commercial banking system and balance of payments, this paper shows that the saving flows from developing countries to industrialized countries cannot increase the funds available for financing investment.

Keywords: saving glut, financial crisis, capital inflow, balance sheet

1.     Literature Review

There is little doubt that the low interest rate is one of the core causes of the U.S. housing bubble and the broad credit boom that spawned today's financial crisis.  However, there is a divergence of views about whether the "easy money" policies of the Federal Reserve or net savings flows created by global imbalances is the proximate determinant of low interest rate, especially lower long-term interest rate in the world.

Bernanke (2005) releases his “unconventional” argument on a global saving glut[1]to explain both the increased reliance on foreign credit (borrowing through current account deficit) and the relatively low level of long-term real interest rates.  The Chinese trade surplus is called a proportion of this global saving glut. Bernanke (2008) resurrects his saving glut perspective and attributes a substantial increase in the net supply of savings in emerging market economies contributed to both the U.S. housing boom and the broader credit boom.  Greenspan (2005, 2009) expresses a similar point of view.  Wolf (2008) claims the roots of the crisis are sustained capital inflows - the parallel of current account surplus. Krugman (2009a, 2009b) endorses Asian countries exporting capital (official foreign exchange reserves) resulting in cheap money flooding the world and causing the global debt crisis.

DeLong (2005) uses the IS-LM model to explain that the low interest rate results in excess liquidity in financial market but not saving glut in real sector. Bracke and Fidora (2008) employ a structural VAR approach to find out that a “liquidity glut” (monetary shocks) may have been a more important driver of the real and financial imbalances in the US and emerging Asia than a “savings glut”. Zhou Xiaochuan (2009a, 2009b) explains the changing structure of China’s savings rate and has discussed this as the main driving force behind the savings rate of China and other oil exporting countries.

Theoretically speaking, the interest rates are determined by money supply and term structure. This paper examines the channel that the net saving flow transmits its effect on interest rate in the industrial countries —notably the United States and finds there are both conceptual and empirical problems. Section 2 of this paper tracks the source of official foreign exchange reserves in developing countries using the balance and payments and consolidated balance sheets of commercial banking system in deficit countries, and finds the net saving flow cannot inflect the money supply in the deficit countries at all.  Section 3 discusses the conceptual paradox in relationship between the long term interest rate and the global saving glut. Section 4 is the conclusion.

2.     Saving Glut, Capital Inflow and Money Supply

2.1.     The relationship between the saving flow and the capital flow

According the System of National Accounts (SNA), in any given period, we have this identity:

NX=S-I                                                                        (1.1)

Where NX is net exports or trade balance, S is national saving, I is investment. In China and other emerging Asian economies and oil exporting countries national saving is greater than its investment, or S>I; then Equation (1.1) implies that NX will be positive. That is, these countries have trade surplus. In contrast, U.S. national saving is less than its investment; therefore the U.S. has a trade deficit.

In any given period, the balance of payments identity states that:

NX+KI=0                                                                     (1.2)

Where KI stands for net capital flows^[2], it represents the difference between sales of assets to foreigners and purchases of assets from foreigners no matter where the assets are located and which currency is denominated. Equation (1.2) tells us that if a trade deficit exists so that NX<0, then it must be true that KI>0, a net capital inflow.  This means that purchases of domestic assets by foreigners are greater than purchases of foreign assets by domestic residents. 

Substitution (1.2) into (1.1), we obtain:

S - I = - KI                                                                     (1.3)

Equation (1.3) is a key result and links the saving glut to the net capital flows. It says if a country’s national saving is less than its investment, net capital flows KI must be positive, which implies this country has a net capital inflow. Bernanke deems that capital inflows augment the domestic saving pool, increasing the funds available for investment in physical capital.  In his textbook (Frank & Bernanke, 2007), Equation (1.3) is written as:

S + KI = I                                                                       (1.4)

Given a explanation that “the sum of national saving S and net capital inflows from abroad KI must equal domestic investment in new capital goods, I. … the pool of saving available for domestic investment includes not only national saving but funds from abroad as well”^[3]. This explanation indicates the hypothesis which Bernanke and others uses to convict China and other economies for their over saving.  They believe the net capital inflows from China and other economies brought extra money to industrialized countries and created excess liquidity.  But they are wrong on this point because there are not any funds from abroad produced by this net capital inflows.

2.2.     Net capital inflow but not funds inflow

Net capital inflows, or the net assets purchased by foreigners from domestic residents, as the counterpoint of trade deficit does not involve any funds inflow from abroad. The payment made by foreigners for their net buying assets from domestic residents is just the goods and services, or the trade balance in the physical not in the financial.

To simplify this issue, suppose the U.S. imports only $1000 goods from China in a given period.  The payment itself is the U.S. bank balance given to the Chinese exporter. ^[4]  Then the Chinese exporter sells the $1000 U.S. bank balance to the People’s Bank of China (PBOC, the central bank of China) and the PBOC buys $1000 U.S. Treasury securities.

Firstly, the U.S. debit goods import for $1000, then drawing down the U.S. bank balance as payment it is then entered as capital credit (capital inflow) in the U. S. balance payments[5].  The transaction in which the Chinese exporter exchanges $1000 bank balances for RMB at PBOC will not enter the U.S. balance of payments at all since this is between two foreigners. Then the purchase of U.S. Treasury securities by PBOC in recorded as a capital credit (capital inflow) and the $1000 payment is entered as a capital debit (capital outflow) in the U.S. balance of payments. There is no effect on the net capital flow for the U.S.

In the end of this period, the U.S. trade deficit is $1000 and the net capital inflow amount is $1000, but there are not any funds that leave the U.S. for China or go into the U.S. from China associating these trades. This is shown in the hypothetical consolidated balance sheets of U.S. commercial banking system (see Table 1, Table 2, Table 3, and Table 4).

Table 1: Consolidated balance sheet of U.S. commercial banking system (initial)

Table 2: Consolidated balance sheet of U.S. commercial banking system (completed trade settlement)

Table 3: Consolidated balance sheet of U.S. commercial banking system (PBOC holds the U.S. bank balance)

Table 4: Consolidated balance sheet of U.S. commercial banking system (PBOC hold the U.S. Treasury securities)

The consolidated balance sheets show that, from start to finish, although the deposits change hands from the U.S. importer to the Chinese exporter and return to the U.S Treasury after the PBOC has paid for the U.S. Treasury securities, the total bank deposits, and hence the U.S. money supply, do not change.  Since the Federal Reserve keeps the deposit reserve rate and the federal funds rate unchanged, the reserves and loans in the assets side of balance sheet also do not change.  The funds available for investment in the U.S. are the same as before import and capital inflow “from China”. 

At the end of this case, China lends $1000 to the U.S. Treasury. However, the $1000 is not created by China, but acquired via trade, and it is just a part of the initial money supply controlled by the Federal Reserve and created by the U.S. commercial banking system.  If there is cheap money, it must be made cheap by an easy money policy and over-lending from the U.S. commercial banking system.

3.     Actual Saving, Desired Saving and the Long Term Interest Rate

3.1.     The long term interest rate determine paradox

Bernanke (2005) and Greenspan (2005) argue that, the trend reduction in long-term interest rate surely reflects an excess of desired saving over desired investment.  Formulizing it, we have

△long-term interest rate=¦(desired saving - desired investment)                              (1.5)

However, we can directly observe only the actual flows, not the saving and investment desired.  If we suppose the desired saving is ‘actual saving + A’, the desired investment is ‘actual investment + B’, Equation (1.5) can be rewritten as[6]

△long-term interest rate=¦(actual saving + A - actual investment - B)                        (1.6)

According to Frank & Bernanke (2007), in an open economy, actual saving is the sum of domestic saving S plus the saving inflow from abroad KI, actual investment is I, and then we obtain

△long-term interest rate=¦ (S+KI + A - I - B)                                              (1.7)

Since in any given period, equation (1.4) must be held, the sum of S and KI must equal I, the excess of desired saving over desired investment must be A-B.  Because the gap between desired saving and desired investment cannot be changed no matter the size of actual trade deficit or capital inflow, the actual trade deficit or capital inflow cannot effect the change of the real interest rate according Bernanke (2005) and Greenspan (2005). This creates a paradox. If long-term interest rate is determined by the gap between desired saving and desired investment, there will be no room for the role of actual capital inflow; if net capital inflow reduces long-term interest rate in practice, the excess of desired saving will not be the root of the long-term interest rate movement.

In fact, the net import (trade deficit) is not saving but expenditure by domestic residents. From the funding perspective, importers have to use their accumulated savings embodied in assets as payment, which is the net capital inflow itself. No domestic investment can be financed by such net capital inflow (assets that have been sold). Thus, the net capital inflow should not be included in, or rather, deducted from the pool of saving available for domestic investment, and has no negative effects on the domestic interest rate.

3.2.     The data observed and empirical analysis

Since that the net capital inflow has no effect on domestic money supply, the central bank is able to set interest rates, at least short –term interest rates, at its target. However, Greenspan (2009) argues that it is not the lower Federal Interest Rate(Fed rate) but long–term interest, which had linked to the short-term U.S. interest rate closely before 2002, but was driven lower by an excess of global intended savings relative to intended capital investment afterwards. Figure 1 shows the development of the U.S. short term and long term interest rates. In Figure 1, 10 year government bond yield and mortgage rate decreased gradually when Fed rate decrease sharply from 2000 to  2003, then increased gradually when the Fed rate increase sharply after 2004.1n 2006 and 2007, 10 year government bond yield  was even less than Fed rate.

In most textbooks about finance, the difference between long-term rate and short–term rate, i.e. the term structure of interest rates, is a fundamental concept.  The demand and supply structure is one of multiple factors used to explain this concept.  However, the data does not consist with the presupposition that purchasing long term Treasury securities by the foreign governments is the determinant force behind the lower long-term interest rate in the U.S. Figure 2 brings forth the purchasing of U.S. Treasury securities by rest of the world. 

Fig. 1: The U.S. short term and long term interest rate

Source: International Financial Statistics

Fig. 2: Rest of the world long term Treasury securities asset(Millions of U.S. dollars)

Source: Department of the Treasury, Federal Reserve Board

Comparing Figure 1 and Figure 2 we can find that the purchasing of U.S. Treasury securities by Rest of the world is not the determinate factor of the U.S. long term interest rate[7].

4.     Concluding Comments

The global saving glut is not the root of the global excess liquidity and low interest rate in the U.S. or other mature industrialized countries.  Although the trade deficit and net capital inflow  are created together and have the same number recorded in the Balance of Payment, the “physical flow” of saving (trade deficit) and the “capital flow” of saving (net capital inflow ) do not necessarily move in correlation. Actually, goods and labour services flow across the frontier from the surplus countries to the deficit countries.  Meanwhile the “capital flow” is only a part of original funds supply in deficit countries, not re-injected funds into these countries’ financial markets from outside.  Therefore foreign exchange reserves and “sovereign wealth funds” accumulated by trade surplus form the “capital flow”, can neither increase the money supply of the U.S and the U.K, nor be the driving force of housing market prosperity or other broader credit booming in the world.

In conclusion the excess saving, which has been lent on international capital markets by China and other countries that has trade surplus with the U.S., is only the transferred fund created by the Federal Reserve who conducted an easy money policy and induce the U.S. residents buy more than their income allowed.  Because the U.S. Dollar is a vehicle currency, and there was an unrealistic belief in the stability of the value of the U.S. Dollar, through monetary expansion Americans can divert real savings from other countries and carry out their huge negative savings.

5.     Acknowledgements

The research required for this paper was supported by the Program for New Century Excellent Talents in University (NCET-08-0762). The author would like to express thanks to Feng Fan for his assistance in the preparation of the paper .

6.      References

[1]       Bernanke, Ben S., The Global Saving Glut and the U.S. Current Account Deficit, At the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia. March 10, 2005.

[2]       Bernanke, Ben S., Remarks on the economic outlook at the International Monetary Conference, Barcelona, Spain, June 3, 2008.

[3]       Bracke, Thierry and Michael Fidora, Global Liquidity Glut or Global Savings Glut? A Structural VAR Approach, European Central Bank working Paper No. 911, June 2008.

[4]       DeLong J. Bradford, Global Excess Liquidity, Economists, August 12, 2005.

[5]       Frank, Robert H. and Ben Bernanke, Principles of Economics, McGraw-Hill Companies, Inc. 2007

[6]       Greenspan, Alan, The Fed Didn't Cause the Housing Bubble, The Wall Street Journal, 11 Mar 2009.

[7]       Krugman, Paul,  Revenge of the Glut,  The New York Times, March 1, 2009 ,

[8]       Krugman, Paul , Reagan Did It,  The New York Times, May 31, 2009

[9]       Wolf, Martin., Asia's revenge, Financial Times, October 9 2008. 

[10]   Zhou Xiaochuan, Some Observations and Analyses on Savings Ratio, Speech at the High Level Conference Hosted by Bank Negara Malaysia on 10, 2009, in Kuala Lumpur, Malaysia.

[11]   Zhou Xiaochuan, Address at the Global Think-tank Summit, 3 July 2009, Beijing.