Can the G-20 Get China to Spend and the US to Save? [Harvard Business]

The G-20, the group of the world’s largest economies, agreed last week to a US-led initiative called a “Framework for Sustainable and Balanced Growth.” This is an effort to rectify current global imbalances in trade and capital flows, in which the US runs huge trade deficits financed by huge Chinese investments in US Treasuries.

The solution? Chinese consumers should spend more and US citizens should save more. Progress on meeting these objectives will be monitored by the International Monetary Fund, which will periodically issue a global scorecard.

While these are laudable objectives, they will be difficult to achieve. Consumer spending in China constitutes only 36% of its GDP, roughly half of the level in the US. At the same time, the personal savings rate in China is amazingly high — the average savings rate for urban Chinese households rose from 15.4% in 1995 to 22.4% in 2005.

And there are good structural reasons why Chinese households save so much and spend so little. First, China has nothing close to universal healthcare, despite its Communist ideology. So when a medical emergency arises, most Chinese families must pay large sums in cash to get treatment. To persuade Chinese families to consume more and save less, therefore, China must fully meet the healthcare needs of its citizens.

When China announced its initial stimulus package of $585 billion in late 2008, it was largely comprised of infrastructure spending and business incentives. During 2009, China did expand the stimulus package to include $120 billion to improve local healthcare. This is a step in the right direction, though not enough to solve the problem.

Second, if China wants its consumers to spend more and save less, it must substantially improve its Social Security system. China’s modern retirement system, begun in 1997, does not cover most workers in rural areas or in small urban enterprises. In addition, workers can no longer count on their children to support them in old age.

Most problematically, contributions to the current retirement system are made to provincial governments, which must pay out legacy benefits on pre-1997 pensions that were never funded. This is an unviable situation for provincial governments and Chinese workers. Instead, China’s national government should assume all obligations under the pre-1997 legacy pensions.

The challenges are equally daunting on the American side. The good news is that the personal savings rate of American households is rising: from negative 2% in 2005 to positive 6% during 2009. This means roughly $600 billion in incremental savings and reduced spending by consumers.

The bad news is that the US budget deficit is rising more quickly than our personal savings rate. In fiscal year 2008-2009, the US budget deficit will be $1.6 trillion. Over the next decade, the budget deficit is projected to average $1 trillion per year, according to the Brookings Institution.

Will Congress reverse these US budget deficits by letting the Bush tax cuts expire at the end of 2010? In theory, this could raise tax revenues by approximately $1.6 trillion over the next decade. However, only $700 to $800 billion of the Bush tax cuts went to wealthy Americans with annual incomes over $250,000; the other $800 to $900 billion went to middle and working class families. Maintaining low tax rates for these families will be strongly supported by both Democrats and Republicans, so the chances of Congress renewing the majority of the Bush cuts are high.

At the end of the day, the US budget deficits will fall and total US savings will rise only if Congress constrains the growth of public spending. This was done during the 1990s through a bipartisan measure called PAYGO — whereby public spending could not be increased unless it was paid for by other spending decreases and/or tax incentives. As a result of PAYGO and other factors, the US ran a budget surplus in 2000.

Congress could adopt a version of PAYGO to become effective once the economy rebounds (i.e., when GDP grew by at least 2% a year). In fact, the Obama Administration has proposed a form of PAYGO to constrain the growth in budget deficits. However, that proposal is filled with exemptions exceeding over $2 trillion — for Medicare payments to doctors, fixes to the alternative minimum tax and, of course, continuation of the Bush tax cuts for families with incomes below $250,000 per year.

In short, for the G-20 to succeed in correcting global imbalances and achieving sustainable growth, both China and the US would have to adopt bold measures involving significant financial and political issues. When the IMF begins to issue its reports, we will know whether either country has made substantial progress in achieving these worthy objectives. How likely do you think it is that they’ll get good report cards?

Bob Pozen is a senior lecturer at Harvard Business School and the author of Too Big to Save? How to Fix the US Financial System (November 2009)

Insuring China’s Future [Wall Street Journal]

The Senate Banking Committee just approved a tighter definition of currency “manipulation” and the Finance Committee recently increased the penalties for alleged currency manipulators. While both committees are trying to reduce the large U.S. trade deficit with China, it would be more fruitful to examine the reluctance of Chinese consumers to buy imported goods and services. They understandably have deep concerns about their country’s weak social safety net. And without adequate retirement security or catastrophic medical insurance, rational Chinese consumers will continue to be aggressive savers and reluctant spenders.

In response, the National People’s Congress is about to consider a major overhaul of China’s social insurance laws: This presents a unique opportunity to put China’s social security system on sound financial footing. But the NPC will have to overcome two formidable barriers — the financial drag of legacy pensions from the pre-1997 economy and the local administration of a pension system for an increasingly national workforce.

In the communist era of the “iron rice bowl,” state-owned enterprises regularly promised pensions to workers, who made no pension contributions. In 1997, as China moved toward a market-oriented economy, it adopted a two-tiered payroll tax to finance social security (primarily in urban areas). Employers now should contribute 20% of wages to support a defined retirement benefit. Employees also are now required to contribute 8% of a worker’s wages to a personal account, with a variable retirement benefit based on investment returns.

The responsibility for paying social security benefits rests with local governments — provinces, cities or townships — which also collect the payroll taxes. Unfortunately, these local governments are using much of the employers’ 20% payroll taxes to pay pre-1997 legacy pensions to workers who never made any contributions.

Many local governments have even paid legacy benefits with some or all of the 8% in payroll taxes contributed by workers, which are supposed to be invested in personal accounts. Despite recent pilot programs by the national government in several provinces, a substantial portion of these personal accounts are not funded with actual investments — they are “notional” accounts with only paper credits. If these personal accounts remain “empty” until participating workers reach retirement, the result will be a new set of large, unfunded liabilities for local governments.

The solution is to pre-fund retirement benefits by holding the contributions in separate trusts and investing them. This would avoid the huge unfunded liabilities of pay-as-you-go social security systems, like those in the U.S. and Europe, where the number of active workers supporting each retiree is declining. China will face a particularly steep decline because the government is holding down population growth through its one-child-per-family policy.

Researchers Yaohui Zhao of Peking University and Jianguo Xu of Duke University have estimated that China could reduce the employer portion of its payroll tax to below 16% if it pre-funded the social security system. Such a reduction would broaden the participation of Chinese employers in the system. Right now, faced with a 20% payroll tax on top of other employment-based taxes — which together exceed 60% of payroll — only half of China’s urban employers make social security contributions. The system is virtually non-existent in rural China.

The present system, which uses current payroll taxes to pay legacy pension benefits, also undermines China’s heightened efforts to crack down on corruption. If local officials do not have to deposit all taxes in a separate trust, some will be tempted to divert the money for personal gain. Chinese prosecutors recently brought criminal actions against two senior officials in Shanghai for allegedly diverting pension funds to corrupt entrepreneurs.

To facilitate pre-funding, the NPC should shift the responsibility for paying legacy pensions to the national government. To finance legacy pensions, the national government could allocate a modest portion of its $1.3 trillion in reserves to the national social security fund. This fund already invests the proceeds from certain privatizations of state-owned enterprises to help local governments defray their pension obligations. In return, the NPC should insist that social security become a national system. Provincial officials are pushing hard to become the consolidators of social security for local governments because of the significant economic and demographic differences among regions. However, provincial officials in China are not well positioned to invest payroll taxes in diversified portfolios. More fundamentally, as workers move in response to changing employment demands in different regions, they need benefits that are easily portable and financially secure.

With social insurance legislation on the table, now is the time for the NPC to negotiate the grand bargain — relieving local governments of legacy pension obligations if they cede social security to the national government, and persuading the national government to invest all payroll taxes in trusts or other accounts dedicated to pre-funding the social security system.

Mr. Pozen is chairman of MFS Investment Management.