The world is experiencing an unprecedented glut of savings, driving down real interest rates. It is a good time to borrow rather than lend, and to buy equities rather than bonds. This has implications for central banks, corporations and individual investors.
China is investing $3 billion, a tiny fraction of its $1.2 trillion of reserves, in Blackstone, a U.S. private equity company. More such equity investments will surely follow. India, OPEC members, and other developing countries with large foreign exchange reserves should emulate China's strategy.
Foreign exchange reserves are typically invested in bonds of G-7 countries, above all in U.S. Treasury bonds. Former Treasury Secretary Larry Summers estimates that developing countries are holding more than $2 trillion of reserves in excess of their needs to combat currency volatility. If this excess is invested in equities rather than bonds, the resultant gains could exceed $100 billion.
In the 20th century, developing countries struggled to accumulate enough forex reserves for bare safety. They had low savings rates, and needed funds from rich countries to meet investment needs. The two-gap theory of development economics portrayed poor countries as suffering from a chronic savings gap and trade gap.
But today things have changed dramatically. Several developing countries are running large current account surpluses (representing an excess of savings over investment). So they are accumulating surplus dollars. China has the biggest surplus of $1.2 trillion, but other developing countries put together have accumulated almost as much. And oil exporters are accumulating reserves at the rate of $300 billion per year.
Rapid growth leads to high savings rates: people save a large fraction of additional income. In India, GDP growth has accelerated from 6% to 9%, lifting the savings rate from 23% a decade ago to 33% today. China's savings rate is a dizzy 55%. Not even the investment boom in Asia can absorb these huge savings, which are therefore put into U.S. bonds.
When a poor country buys U.S. bonds, it is in effect lending to the USA. It is paradoxical for the poor to lend to the rich, especially at depressed interest rates. Chastened, developing countries are now creating special financial vehicles to park part of their excess reserves in equities, real estate, and hedge funds. Singapore has led this fashion, and others like Korea, Qatar, Abu Dhabi, and India are following suit.
However, equities and real estate have skyrocketed globally. China's stock market has quadrupled in two years, with a ridiculously high price-earnings ratio of 50. Property prices have tripled in some Asian cities in five years. The saturation of conventional asset markets explains why individual investors as well as governments are now turning to private equity funds, the new stars of the financial firmament. Private equity funds borrow to finance acquisitions, hoping to sell these after reorganization at a profit. This has proved spectacularly profitable in recent years, yielding returns of up to 25% per year. Private equity funds are now big enough to contemplate taking over any company in the world, even General Motors or Exxon.
Is this the right time for developing countries to switch from the safety of bonds into private equity? Are they wise diversifiers, or suckers entering a bull market at its peak? The answer depends on whether the savings glut will continue.
I believe it will. Globalization and new technology are creating steady, sustainable increases in world productivity. This should translate into exceptionally high growth for the world economy, leading to exceptionally high savings. The U.S. is running a record trade deficit with developing countries, underpinning the savings surplus in those countries.
The current global upswing will not last forever. It has lifted even sub-Saharan Africa to 6.3% GDP growth, and nobody believes that is sustainable. Sooner or later, a global downswing will come. GDP growth will slow down, and so will excess savings. At that point equity markets will fall, and highly leveraged private equity funds (and corporations and private investors) could be in trouble.
Yet in the new era of globalization and technical change, the average rate of global savings should be much higher through the ups and downs of the business cycle. In which case borrowing to buy real assets will continue to be a good long-term strategy, despite attendant risks.
Top Indian and Chinese companies certainly think so, and are buying Western companies in leveraged deals. Tata Steel recently acquired Britain's Corus for $13.2 billion, of which two-thirds will be borrowed. Birla acquired Novelis for $6 million, of which $2.4 billion will be borrowed. Global financiers are happily financing Indian minnows to take over Western whales. They believe, implicitly, that the savings glut is here to stay.