China is awash with cash. The United States is the world's largest borrower. Yet the nations face a similar challenge: balancing consumption and savings in an aging world.
By Jim Jubak
The United States, the world's biggest debtor, and China, the world's biggest creditor, each passed major statistical milestones this month.
In the second quarter, the Commerce Department announced this month, the United States paid more to its foreign creditors than it took in from its overseas investments -- the first time that's happened in 91 years. The gap was relatively small, $2.5 billion for the quarter, when measured against a $13 trillion economy, but it was still a milestone.
At the end of September, China's foreign-exchange reserves topped $1 trillion. Thanks to foreign investment in China and the country's huge trade surplus, China's foreign-exchange reserves are climbing by about $20 billion a month. In recent months, China's reserves have grown so quickly that the country has taken over first place from Japan, with reserves of $880 billion at the end of August.
2 countries on parallel tracks
The two countries couldn't seem to have less in common: The United States owes an increasing debt, and China is piling up foreign exchange at a record rate. But in reality, both countries face the same problems: How do you balance consumption and savings in a rapidly aging world? The U.S. has gone way too far toward consuming without saving, especially considering the huge financial costs that result from the aging of the baby-boom generation.
But China is out of balance, too. The country saves too much and often invests money foolishly. The country is aging even more rapidly than the United States, albeit from a younger starting point. And it has less infrastructure in place to support that aging population than the United States does. China's current cash flow may represent a one-shot opportunity to prepare for the aging of that society.
Each, in its own way, is spending too much on the present.
Is U.S. nearing financial avalanche?
In July, the United States may have reached a tipping point, one of those moments when all the snow that has been building up in the mountains suddenly becomes an avalanche. We've been spending more than we take in with both hands for a while now. But only recently has paying the interest on all that debt really started to cost us very much money.
The United States has piled up a string of monthly trade-deficit records recently. The July 2006 deficit of $68.04 billion, for example, erased the October 2005 deficit of $66.6 billion. For all of 2005, the United States spent $717 billion more on goods and services than it took in -- also a record. So far, 2006 is on a pace to handily surpass that deficit: The January-July 2006 deficit hit $453 billion, way ahead of the $398 billion deficit in the corresponding period of 2005.
At the same time, the U.S. government has been spending more than it took in. Since 2001, the federal government, certainly not the only layer of government practicing deficit financing, has borrowed $1.3 trillion to pay for tax breaks, new Medicare drug benefits and the war in Iraq.
Foreigners make U.S. deficits possible
Foreigners have picked up the tab for most of those twin deficits. Foreign investors have purchased U.S. government bonds that the federal government has used to finance its spend-now, pay-later policies. The dollars we sent overseas to pay for everything from oil to electronics to textiles to toys have been recycled by foreign investors into U.S. government bonds, corporate bonds and mortgage-backed securities (a form of debt backed by the mortgages on U.S. homes). My MSN Money colleague Bill Fleckenstein has railed against the way that we turned our homes into ATMs during the real-estate boom. Well, it was foreign investors buying bundles of mortgages on U.S. real estate who kept those ATMs stocked with cash.
By the end of 2005, overseas investors held $13.6 trillion in U.S. stocks, bonds, real estate, businesses and other assets. Subtract the $11.1 trillion in assets owned by U.S. residents and companies, and the U.S. had a net negative balance of $2.5 trillion. That's about $23,000 for each of the 110 million households in the nation, according to the U.S. Census Bureau.
U.S. net investment income now in red
But as any debtor knows, it's not the size of the debt that counts but the interest rate you have to pay. Until recently, the United States got a great deal on its debt because borrowing money was cheap. Remember that short-term interest rates -- and the U.S. government sells an awful lot of three-month Treasury bills -- were at 1% as recently as June 2004. The 10-year Treasury note yielded just 4.7%. At the same time, because U.S. investors preferred equities to bonds, they were earning closer to 8% on their equity stakes, giving the United States a positive net income on investments, even though it owed more than it owned.
That positive-net-income position has gradually eroded as short-term interest rates have climbed to 5.25%. (Long-term rates, after climbing, are now back pretty much where they started in June 2004.) The closing of the gap between what overseas debtors get paid for holding dollar-denominated debt and what U.S. investors get paid for holding overseas equities has finally pushed U.S. net investment income into the red.
And it threatens to do so more emphatically in the future if U.S. interest rates climb and further close the gap between the yields received by overseas investors on their U.S. investments and the yields received by U.S. investors on their overseas holdings.
Long-term consequences
Why should you care? Because that income flowing overseas is, in effect, a tax on your future. There are only a handful of options available to pay that interest-rate tab:
*Taxes have to go up.
*Inflation has to climb, lowering the purchasing power of the borrowed dollars and the real cost of interest payments.
*Interest rates have to climb to attract enough money back to the United States to finance economic growth.
*The dollar has to fall, so we can pay our debts more cheaply.
*We have to sell more assets to overseas investors.
*U.S. workers have to take more wage cuts.
*U.S. consumers have to cut back on spending.
In all likelihood, paying the bill will involve some combination of all of the above. In any case, all those future interest payments represent dollars that we won't have to spend on meeting the challenge of an aging population. Think the younger generations resent the baby boomers now? Imagine how they'll feel if they have to pay more to take care of the boomers and suffer a falling standard of living, too.
Too much cash is another problem
The Chinese would have it easier, you'd think: All they have to do is sit back (after working like a dog for $2 an hour) and let the money roll in. But managing a river of cash is just as hard as managing a river of debt. If the Chinese don't spend today's foreign-exchange bonanza well, they also face a future of declining prosperity. China is a rapidly aging society that by 2030 is projected to be as old as the United States.
But China, unlike the United States, is a developing country without the infrastructure we take for granted: life insurance, 401(k) retirement plans and Social Security, government health insurance for the very old and the very poor, and a system of private-property ownership that lets the elderly tap into the equity built up over a lifetime to pay for the needs of old age.
You might think that the solution to China's problem is more saving, but it's not. Saving from current consumption to provide for future needs only works if the savings are invested at a positive rate of return and not wasted. Too much of China's flood of cash is going into failing state-owned business or into white-elephant real-estate projects pushed through the system by local officials out to gratify their egos or cement their position in the Communist Party.
Rapid development makes waste likely
The pace of investment is simply too fast to ensure that money isn't being wasted. By August, China's banks had exceeded the loan target set by Beijing for the entire year. That month fixed-asset investments climbed at a runaway rate of 22% from the same month in 2005. (See my column China's economy is out of control for details.)
The recent decision by the Beijing government to suspend a new bankruptcy law for 2,116 of the country's worst-performing state-owned companies even before it goes into effect in June 2007 is a very bad sign. In a recent decision, the Beijing government decided to give these companies until August 2008 before they were covered by the new law.
These companies face claims for back pay and health-care costs from workers that could add up to billions of yuan, the Financial Times reported. The new bankruptcy law would have put workers behind other creditors in the event of a corporate bankruptcy. But the government is afraid of the political unrest that would result from closing hundreds of unprofitable state-owned companies.
The biggest effect of the decision may be to delay yet again the central government's attempt to force banks to lend only to projects that have a chance of a showing a profit. In addition, it may force the central government to spend some of its reserves on bailing out the banks that hold the loans on the worst of these enterprises. The bankruptcy law is intended to create a mechanism that would allow banks to sell off bad loans and the assets of bankrupt companies to investors (often overseas investors). Absent that mechanism, Beijing will have to pump cash into the country's banks to offset these bad loans.
Well, you get the idea.
Initially, it seems odd to think that China and the United States, two countries with such seemingly different sets of "financial books," face the same challenge of properly balancing consumption and savings to produce the greatest future prosperity. That they do speaks to the challenge that the entire global economy faces from a rapidly aging world. Our societies are built on the premise that the next generation will be bigger than the current one and thus well able to take care of its elders.
That's not an assumption that any society -- well, perhaps India for a while longer yet -- can afford to make today. We all, creditors and debtors, need to be better at planning for the future than we are now.
New developments on past columns
A sweeter scenario for 2007: So is 2007 going to be better than expected or not? On Sept. 27, the data delivered a great big maybe. Unexpected good news was balanced on the day by unexpected bad news. First the good news: New home sales actually rose in August by 4.1%. Sales in the month were still down 17% from August 2005, but combined with the less-than-expected drop in existing home sales reported the day before, these numbers show a housing market in correction rather than freefall. Inventories of unsold houses fell to a 6.6-month supply from July's seven-month supply. But before you rush out to buy stocks on the belief that stronger-than-expected housing sales will lead to better-than-expected economic growth in 2007, listen to the bad news. Orders for durable goods -- you know, stuff that doesn't wear out or get used up immediately such as airplanes, cars and machinery -- fell 0.5% in August. Wall Street had been expecting an increase in orders for the month. To rub salt in the wound, July's figures were revised to show a 2.7% drop. Orders for capital goods -- the stuff that companies use to make other stuff -- fell by 2.4% in August after a drop of 2.4% in July. Remember that capital spending by business was supposed to pick up the economic slack created as consumers cut spending due to higher oil prices and declining home prices.
How to invest when trends zig and zag: Those looking for a bottom in natural-gas prices -- and the price of natural-gas stocks -- got big news on Sept. 27 when Chesapeake Energy (CHK, news, msgs) announced that it would shut down about 6% of its unhedged near-term natural-gas production in the southwest United States because of low prices for natural gas. The shutdown, actually called a shut-in by the industry, would reduce production by a net 100 million cubic feet of gas a day starting on Oct. 1. I expect other companies to announce similar reductions in short-term production, especially if they haven't protected their selling price with price hedges, in the next few weeks. Such shut-ins will gradually end the current oversupply of natural gas.
Editor's Note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that Jubak's Picks recommendations are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest-rate environment, see Jim's new portfolio, Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio.
E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak owned or controlled shares in the following equities mentioned in this column: Chesapeake Energy. He does not own short positions in any stock mentioned in this column.