Wednesday, September 5, 2012

Unintended consequences of financial repression

In the context of China's still inflating property bubble, Yichuan Wang has an interesting post where he attributes the housing boom to an absence of alternative investment opportunities. He writes that housing has become a "savings vehicle" for ordinary Chinese citizens,
Chinese citizens face a severe shortage of effective ways to save money or preserve value. Bank deposit rates consistently run below the rate of inflation. When better investment opportunities come along, those deposit rates don't necessarily rise. There are securities companies, but it's very difficult for the people to trust them... The stock market is seen as a capricious creature...
Housing is special because it is much more concrete than other investments. It depreciates relatively slowly and is easy to verify; this is unlike many other investment opportunities such as equities or securities. It is useful, because you can immediately start to live in it or rent it out. Also, because of rising incomes across China, it seems very reasonable that demand for housing will increase and therefore building a house will have a high return.
In other words, China's financial market repression - artificially low interest rates, capital controls, strongly regulated capital markets etc - has been fueling the residential property bubble. He sees this as a constrained revealed preference,
Large scale housing investment is not necessarily a neutral “revealed preference”. Rather it can be a dangerous “constrained preference”. Given the option between negative real rates in a bank account or housing, Chinese citizens choose housing. But if they had the option of higher deposit rates, we might have seen a shift away from housing towards regular bank deposits. This is very similar to the problem developmental economists face when discussing whether people in poor countries have too many children. While parents might prefer to take care of fewer children, they choose to have more children so that enough of them survive to take care of their elderly parents. So similarly, poor people choose to have a lot of children given their constraints, but with enough financial innovation they would consider having fewer children.
In fact, I am inclined to argue that this preference for housing investment as a savings vehicle may be also contributing to keeping savings very high and consumption suppressed. The large amounts required to buy housing, as opposed to other smaller but diversified investment alternatives, increases the need to save more. The rising property values exacerbates this trend. And this in turn is keeping consumption heavily constrained. This is one more reason for Beijing to start addressing the underlying causes for the disproportionately large propensity among households to save. See this and this for an analysis of the underlying reasons.

In this context, it is tempting to draw parallels with Indian households' attraction to investment in gold. In the absence of adequate, easily accessible, low-risk, and liquid enough investment opportunities, they find gold a very good investment opportunity. In terms of gold imports adding to the country's unsustainable current account deficit and the gold stocks locking up a significant share of savings, its dead-weight loss and larger economic cost is clearly bad for the economy. The financial market uncertainty in the aftermath of the sub-prime crisis and the surge in gold prices has only amplified the resource mis-allocation problem.

A recent report by Macquarie (via FT) found that India's net gold imports worth $23 bn (1.3% of GDP) in 2011-12 was almost half of its $44bn current account deficit. It wrote,
Our estimates suggest that net gold imports alone have contributed nearly 40bps to the 130bps widening in India’s current account deficit between FY08 and FY11 (from 1.3% to 2.6% of GDP).
Both these examples of resource mis-allocation which are directly related to financial market repression is a reminder about its adverse consequences on the national economy.