When you earn more than you spend, you save. What do you do with your savings? If it’s a small amount, likely to vary from month to month, you probably let it sit in your bank account or equivalent. The amount the bank owes you increases, and you feel a tiny bit richer. A small, unnoticed by most, effect of this is that you become a tiny bit more exposed to the fortunes of your bank: If the bank fails, you stand to lose a tiny bit more. You have in fact lent your dough to the bank, and you will only get it back if the bank is able and willing to pay you. Many ordinary retail depositors found this out the hard way when the big Icelandic banks proved unable to meet withdrawals in the financial crisis of 2008.
If you’re a bit more sophisticated, or the amount of saving is a bit bigger, you can lend your money to a government by buying its bonds, which are just promises to pay you back in its domestic currency at some future date. That government probably will pay you, but if its currency has lost purchasing power in the meantime, because of inflation or a currency depreciation, you may still not get back what you lent. As a result, whether you thought about it or not, your exposure to that government went up.
Even if you simply take your savings out of the bank in the form of cash and stick them under your bed, you are still lending money. This time you are lending money to the issuer of that cash, which will normally be your government, or if you only trust Swiss Francs, the Swiss government. The difference between that and a bank loan is that the government pays you no interest on your lending. But your exposure to the fortunes of that currency is the same as if you bought its bonds.
If the amount you save is bigger, you probably think about investing it into shares in some of the great companies out there, like Microsoft, Apple, or Alibaba. Or you invest it in a fund such as a mutual fund which then invests your cash in a portfolio of shares in such companies. Your exposure to the fortunes of those companies also increases, in a way which is much more straightforward than that in the previous paragraph: when Microsoft does well, you do well, and vice versa. You have provided your money for Microsoft to deploy (or bought the shares of someone else who provided their money for Microsoft to deploy). If Microsoft deploys it well, as it generally has done very well, then your claim on the future profits of Microsoft increases in value. Microsoft doesn’t have to pay you back.
Finally, if you saved a lot of money, you might buy a house or a piece of land. Again, your investment will go up or down with the value of that house or land, which will generally depend, in the long term, on the economic performance of the region and country where the house is.
What’s my point? Whenever you save, you must choose a way to preserve your savings in a way which increases your exposure to, your risk of, something. In essence, saving is either lending to other people, or investing in equities or housing (which is just a kind of equity). There may come a day when you don’t like any of these alternatives, and so you will choose not to save, to spend the extra and eat it now.
What if instead of you, we are talking about a nation’s savings, such as those of China, or the UK or Saudi Arabia?
All the same principles apply. It’s only the magnitudes which are different. When China saves (by earning more than it spends, historically by exporting far more than it imports by value), it has to lend or invest those savings outside China. Historically it has chosen to invest most of those savings in US government bonds, and more recently other government bonds. China, Japan and the major oil exporters have all become major lenders to the United States government. They have also invested in non-government securities such as US equities and real estate, but these numbers are rather smaller.
Are there any interesting differences between lending/investing by people versus nations? Yes there are. First, there are not so many governments with whom smart, risk-averse nations would like to park their savings: the US, the rich European nations such as Germany, the UK, Switzerland and France, a few small oil-rich nations. The list is short. That means countries that run perennial current account surpluses (exports minus imports) such as China, Germany or Japan, inevitably become major lenders to the few creditworthy governments in the world, basically the EU, the UK, Switzerland and the US. The lenders may not like this situation at all, but they have little choice except to stop saving.
Second, when your bank doesn’t pay you, you can sue it. This is super-inconvenient, but feasible. If the bank can pay you, it has to. Not so with sovereign nations. If Uncle Sam wakes up one morning and decides not to pay certain foreign nations a dime, it doesn’t have to and no-one can make it do so. The US has form in this regard, having confiscated (i.e. cancelled) British-owned debt during World War 2. The President just had to order it. (Things are better now: The President now has to explain to Congress his reasons for doing so. ‘I wanted to’ is just fine as a reason.) Much more recently, Russia found much of its savings `garnished’ (i.e. not to be repaid until a change in circumstances) by the G7 nations following its invasion of the Ukraine.
Surely, you say, no sane country will allow its hard-earned savings to be lent to a country that might just decide not to repay it? As I already explained, it may well have no better alternative.
OK, just invest in that country’s equities or housing instead. How’s that? No better, because those assets too can be garnished or confiscated, as shown to all expat Russians with links to Putin recently. Buying super yachts, the last resort, is an extremely inefficient way of preserving your savings, and ultimately will not work either, since these boats have to be serviced (in Germany, Italy or the Netherlands) or else they sink.
And what about the borrower countries? In a sense they are not choosing to borrow either. America didn’t ask China or Japan to lend it lots of money, but that was the inevitable consequence of China’s and Japan’s export-driven growth: They ended up major creditors of the US. The US also has to spend that money or save it. Generally, America spends the money by running a budget deficit and allowing its debt to increase. Recent research by Lustig and Van Niewerburgh shows that changes in US government debt, unlike emerging markets, is basically a random walk: It is a passive responder to international trade flows (my gloss on their research). That also means that the size of the US debt is potentially unstable if these flows dry up. In accepting the savings of other nations, it may not have much control over the funds available to its government.
By being providers of reserve currencies with stable values over the past 300 years, the UK, then the USA and now even the EU have tapped an extraordinarily cheap source of funding for their governments’ programs. The rest of the world have had to pay their way, either through necessity or inclination (Japan). However, it’s vitally important for everyone to understand that this very convenient situation could change quite quickly if a major saving country should stop saving. This is presently could happen, as China attempts moving from an export-led growth model to a model of growth more driven by domestic consumption. If Beijing’s transition proves to be successful, watch the dramatic and deleterious effects on US government debt.