## Monday, April 19, 2010

### On Consumption and Savings

DEAR INVESTOR JUAN

I have just arrived in Manila from my China trip. I haven't had much free time in the past two weeks to work on articles, so I have to work doubly hard in the coming weeks to catch up. Fortunately, I was able to gather enough material for three to four articles about the nuances of Chinese financial decision making and the Chinese ecomony. I'll start by answering this comment from Hap about consumption and savings in the Philippines.

Dear Investor Juan

Hi Sir! Always good reading from you. Maybe you could find time to write a post about the "ideal" distribution of expenditures and savings in the Philippines. I've been reading how it differs between East and West, but I can't figure out which one has a better model. Thanks!

Hap

Dear Hap,

Before we talk about the “ideal” mix of consumption and savings in the Philippines, we must first understand how these two variables interact and how they affect economies, in general, and an individual’s well-being, in particular.

Macroeconomics Crash Course

Gross Domestic Product (GDP) in terms of inputs to the economy can be expressed with the following equation:

GDP = C + S + T

Where C is consumption, S is personal savings, and T is taxes. What this means is that citizens contribute to the economy by buying stuff, by saving a portion of their income, and by paying taxes to the government.

So where does everything go? C goes to businesses and is used to produce goods and render services for the consumption of individuals; S supplies capital to these businesses for investment, I; T is used by the government to spend for infrastructure and government services. When we have an open economy that can trade with other countries, we also have to account for exports (X) and imports (M). So GDP in terms of an economy’s output may also be stated as:

GDP = C + I + G + X – M

So equating the two equations for GDP above, we get:

GDP = C + S + T = C + I + G + X – M

Using this model, let’s try to determine the underlying reasons behind the significant gap between the consumption and savings mix of Western and Eastern economies, particularly in the US and China.

US Consumption

In the US, people are basically net consumers rather than savers: from the Bureau of Economic Analysis figures above, personal savings in the US have ranged from 1 to 5% in the past five years, which just amounts to just \$1,000 to \$5,000 on an annual salary of \$100,000. Americans love to spend their income on anything and everything, from essentials like food, clothing, cars, and houses to the not-so-essential like gadgets, video games, and entertainment items. So, is having a high consumption rate and low savings rate bad for the economy? Well, at least from the example of the US, it does not seem so: remember, the US is still the largest economy in the world with Japan only at a far second (which China is poised to overtake in the near future). In fact, it is this remarkable appetite for consumption that has driven the US economy in the past decades; a high consumption level (high C) drives the demand for products and services upwards and boosts the profitability of businesses, which in turn leads to overall economic growth (high GDP). The danger of having a low personal savings rate, though, may be seen more clearly from the perspective of the individual; an American with low personal savings, or does not have anything invested in valuable assets like real property or securities, runs the risk of financial ruin in times of recession or economic crisis. What will you do if you get laid off and you don't have enough money in your bank account for your basic needs? You first try to live on whatever asset you have; if you are a home owner, you try to borrow against the value of your home (so you see how this gets worse when real estate prices plunge, as what also happened last year). And once you've used all of your assets up, where else can you go?

China Savings

Americans are fortunate in the sense that they have a relatively well-developed welfare system that citizens can turn to in case of dire need, especially with the recent passage of the Patient Protection and Affordable Care Act. In China where the health care and education infrastructure is still very much undeveloped for around 90% of the population, especially in rural areas, saving has become a matter of survival. To prepare for the future, something which the Chinese government can't help with, the Chinese are saving anywhere from 20 to 30% of their income (I've actually spoken to two Chinese nationals in Beijing who are able to save as much as 40% of their disposable income religiously), a far cry from the experience in the US. With the low consumption level this very high savings rate implies, how has the Chinese economy been able to grow at a staggering rate of 8 to 10% per year in the last 10 years? Even with this low consumption level, the Chinese economy is still able to grow at a fast clip because of high government spending, G, and high exports relative to imports, X - M.

The Effects of the Financial Crisis on Consumption and Savings

During the financial crisis of 2008 and 2009, what happened, happened: people in the US were either laid off or demoted, leading to lower disposable incomes; Americans reacted by saving a bit more and consuming less; since China's exports go mainly to US markets, the depressed US consumption lowered the demand for China's exports; to make up for this, the Chinese government tries to motivate its citizens to buy more, which leads to saving less; all of this leads to China experiencing a trade deficit, its first since 2004.

The Better Model and What This All Means for the Philippines

One of our China trip speakers, Dr. Men Ming, a finance professor at the University of International Business and Economics in Beijing and a Fulbright scholar, mentioned something very insightful about the ideal savings rate in China. When people save their income, the money most often just goes to savings deposits, which the banks, in turn, lend to individuals and businesses, and use for other financial services. In China, the predominant banks are those which are owned by the state; according to Dr. Men, decisions made by these banks are sometimes questionable and are often tainted by allegations of corruption. So, for both the economy as a whole and the welfare of the individual, he proposes to lower savings and increase consumption so that: (1), the consumption increase can help boost local demand for Chinese products and drive GDP growth, and (2), shift the decision-making applied to funds from banks back to the individual.

So what does this mean for us? I don't have exact savings figures for the Philippines, but I believe we save only a little more than Americans, probably from 7 to 8% of our income. We have the same appetite for consumption as Americans (ya gotta love those iProducts) even if our welfare, health care, and educational systems are probably just as bad as (if not more so than) China's. On the good side, our banks, in general, are more transparent and trustworthy than the state-owned banks in China (except those small, under-regulated rural banks, of course). Personally, I still advise that we save more than 10% of our income, if just to prepare for a rainy day; I think the government still has not reached that level of political maturity and will to pull off something like what Obama did for health care, and it would be stupid to solely rely on what government can provide.

But as we've discussed in several articles in the past, we have to remember that saving should just be the start; once we are able to accumulate enough capital, we should start looking for ways to earn better returns than those provided by savings accounts. More on this on the next post!