Friday, February 27, 2009

Is There Correlation Between Savings Ratio & Current Account Deficit?

Household savings ratio: Defined as percentage of disposable income that is saved. For instance if one’s disposable income is RM 3000 & that person spends RM 2400 per month on average, he left RM 600 for himself. In percentage we say his savings ratio is 20% (considered high for a Malaysian)

Current account balance: Defined as the sum of 4 separate balances which include net trade in goods, net trade in services, net investment income & profits from oversea assets & net transfers

Source: tutor2u

Source: tutor2u

Is there likely any positive correlation between the household savings ratio & current account balance?


Source: BBC (Interest rates in US earlier on)

Source: BBC (Interest rates in UK earlier on)
It is very obvious that savings ratio in both US & UK have been steadily declining since early 1990s. Well, this is not surprising given that both economies pursue consumption-led growth. The component of household spending itself actually makes up about 70% of both US & UK’s GDP. It became more apparent somewhere around 2001-2005, when MPC slashed interest rates from 6% high & since then rates were low, lingering around 4%-4.5%. This had encouraged more consumer spending. The same goes for US, when the Fed continuously cut interest rates from 6.5% high in 2001 & since then base rates were standing at only 1%-1.5% until 2005. Furthermore the people in both places have high marginal propensity to import. What this means is, any increase in disposable income will led to large proportion of that income spent onto foreign goods & services

Contrast, 80% of the world trade surpluses come from Germany especially, China, Japan & oil rich gulf nations. Germany for instance, had savings ratio around 11% compared to UK 3%. High level of savings, lower personal debt & lower appetite for imported goods & services can be few of the reasons to explain the success of Germany in maintaining such a high current account surpluses

Not really (evaluations)

While savings ratio can be a good barometer to indicate the positioning of current account, it is considered insufficient. Let’s consider Japan. Despite a sharp fall in savings ratio over the years, still it is able to yield high current account surpluses

What are the possible reasons for this?

(1) Comparative advantage in manufactured goods. The Japanese knew that they can produce cars, electrical appliances & high quality electronic goods at a lower opportunity cost than many other countries. Large investment onto capital goods earlier on results in higher productivity & lower costs per unit of goods. The impact is magnified with large pool of skilled workers. Furthermore, they have successfully captured the world market share in terms of exports, giving them superb advantages in EOS. Over the years, Japan also receives large amount of FDI. Increasing number of foreign production plants also boost their exports. Having all these, no wonder Japan pursue export-led growth

(2) Undervalued exchange rates. Due to the long depression in its economy since 1990s, the Japanese monetary authority had decided to introduce 0% interest rate at March 2001. It was kept at this level until July 2006. In that period many wealthy foreigners, asset management companies, financial institutions etc had withdrawn their savings from Japan in search of other countries which provide higher interest rates. This caused yen to depreciate. Falling yen benefits its manufacturing sector as Japanese goods will be cheap. Simultaneously, desire for imported goods will fall due to falling purchasing power of yen. Rising exports with falling imports will widen the surplus in current account

(3) Increase in investment income & profits. This is strongly tied with 0% interest rate policy. Theoretically, one may argue that savers are still better off since in period of deflation in Japan (falling price level), real interest rates will increase. Consider this, 0% - (-2%) = 2%. However, not all savers were able to see things that way. As such, many rich Japanese withdrew from their country & parked their monies in Australia, US, UK & Europe that time hoping to gain from the differential in interest rates. This phenomenon is called yen carry trade. In couple of years, it had contributed significant surplus in investment income & profits for the Japan’s current account

(4) Strong economic growth in US & Euro-land. In early 2000s economic growth in US, UK & other European economies were robust, generating a large appetite for Japanese goods such as LCD TVs, cameras, cars etc which are classified as luxury goods. In other word, having YED > 1. This is because an increase in income, will generate a larger than proportionate increase in demand for such goods. This further boosts its exports. Having said so, there is not much of an increase after all in its value as % of GDP. Probably the rise in China as another manufacturing hub, had more or less eroded its comparative advantage


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