China’s debt has quadrupled in the last few years, from about $7 trillion in 2007 to $28 trillion by mid-2014. This increasing debt burden combined with the recent economic slowdown suggest a gloomy outlook for the Chinese economy, not to mention the rest of the global economy. Yet China also has one of the highest savings rates in the world (next only to Kuwait and Bermuda) at 50% of gross domestic product as of 2013, according to the latest figures from the World Bank. 

Far from being paradoxical, high debt is actually to be expected in an economy with a high savings rate. However, this should not lead to the conclusion that China’s debt is nothing to worry about; in fact, it may just be an indicator that the Chinese are saving too much. That’s right, high savings rates aren’t necessarily a good thing. Below we explore these paradoxes and why China may need to reduce its savings in order to reduce debt and fuel growth.

The Macroeconomics of Debt and Saving

Let’s begin by looking at a simple closed economy with no exports or imports. In standard macroeconomic theory, the total output of nation without international trade can be expressed as: 

Y = C + G + I

In this equation Y can be defined as either total output or total income, which is a result of consumption spending (C), investment spending (I) and government spending (G). Rearranging this equation we can define investment as a function of total income minus both consumer and government spending:

Y - C - G

What is interesting here is that savings are generally defined as income minus spending (i.e., whatever isn’t spent is necessarily saved). Thus, using S to indicate saving we could write:

Y - C - G

Which leads to the conclusion that savings equals investment:

= I

What people save, so long as they don’t put it under their mattress, will be used to finance investment spending.

One Person’s Savings is Another Person’s Debt

There are generally two different channels by which saving is transformed into investment spending: equity and debt. As long as savings are directed into equity financing, then the economy will not incur any debt. However, much of investment is financed through bank loans and bonds, which constitute debt. Thus, in a simple closed economy example, debt is just the result of an economy transforming its savings into investment.

Now, in an open economy things are a little different. Even countries with low savings can build up significant amounts of debt by borrowing from the rest of the world. If domestic saving is less than domestic investment (S < I), then the country will need to borrow from the rest of the world in order to finance its investment spending. The U.S. economy fits into the category of low savings and high debt, a position sustained by borrowing from foreign nations. (To read more see, "How Savings Are Saving the Economy.")

China’s total debt as of 2014 was $28 trillion. Of that, the total external debt (money borrowed from foreign nations) reached $0.949 trillion by the end of 2014. This means China's total debt to foreigners was only about 3.4% of its total overall debt. This shows that most of China’s debt is financed by domestic savings.

So What’s the Big Deal?

Conventional wisdom on personal finances suggest that high savings are good. If we consider debt as an effect of an economy transforming its savings into investment, China’s debt should be nothing to worry about. Yet, conventional wisdom at the level of personal finances doesn’t always carry over to the macroeconomic level.

So long as most of China’s debt is domestically owned and denominated in domestic currency, China’s recently high levels of debt are manageable. But, there are signs that despite low levels of external debt, China's debt is not all healthy. Between 2007 and 2014, China’s debt-to-GDP ratio grew from 158% to 282%, evidence that debt growth is rapidly outpacing GDP growth. 

The Limits of Investment-Fueled Growth

Looking at the composition of China’s debt by sector reveals the real source of the country’s debt problem. Between 2007 and 2014, government debt rose by only 13% and household debt by 18%, while corporate debt rose by a whopping 52%. Non-financial corporate sector debt, reaching 125% of total debt to GDP, was the main culprit of the explosion in Chinese debt.

This should come as no surprise as much of China’s rapid economic growth over the last few decades was based on an investment- and export-led growth strategy. High household savings allowed for greater investment and capital accumulation that was being driven by foreign consumption. What has become increasingly evident since the global financial crisis are the limits of that strategy.

The fact that debt-financed investment is outpacing economic growth shows that increasing levels of investment are not translating into greater productivity. Further, slower global economic growth is having a negative impact on China’s exports. While annual growth in merchandise exports averaged around 18% from 1990 to 2014, they grew by only 6% in 2014, and fell by 1.9% in the first nine months of 2015.

A big part of the solution to the problem, oddly enough, lies in China’s high savings rate. Investment spending by Chinese corporations has hit a wall, a wall that Chinese consumers have the means to break down by tapping into their savings. That large fund of savings needs to be redirected from investment spending to consumer spending. With increased consumer spending, China’s corporations can use the revenue from that spending to service and pay down their debts, while providing a new direction for a more sustainable economy driven by consumption rather than exports and fixed investments. (To read more, see, "China’s Economy: Transition to Sustainable Growth.")

The Bottom Line

High savings rates are useful for developing economies as they contribute to greater capital accumulation, making the economy more productive in the long run. But high savings rates come at the cost of lower consumption. At a certain level of development, high savings rates can also lead to over investment. It appears that China is finding itself in this situation as it attempts to transition from a developing to developed nation. If China can induce its consumers to save less and spend more, it would take the burden of driving economic growth off of the industrial sector and help to relieve the debt burden.