China: The risk of chronic financial instability

The very high savings rate of the Chinese leads to a risk of chronic financial instability in China via two mechanisms: Due to China’s controls on capital outflows, Chinese savings must primarily remain in China. At equilibrium, this very high level of savings inevitably gives ris e to a very high level of debt, since these savings must be lent to the domestic economy. This explains China’s very high debt ratio; The small size of China’s domestic markets for financial asset s (equities, bonds) means that most of China’s savings are invested in low-yielding bank deposits. This explains why the Chinese seek to invest their savings abroad, resulting in sizeable capital outflows - which would be huge without the capital controls. These chronic capital outflows may drain China’s foreign-exchange reserves to the lowest level deemed acceptable by the authorities. When this happens, there will no longer be able to be any currency intervention to stabilise the renminbi, potentially leading the currency to depreciate sharply. China’s very high savings rate makes it possible to finance high levels of investment and fiscal deficits . B ut it also creates financial instability by giving rise to a very high debt ratio and massive capital outflows.