Underdeveloped financial markets and rapid economic growth are the most important forces driving China''s massive outflows of financial capital and inflows of foreign direct investment (FDI) in recent decades. That is the central finding of research by Pengfei Wang, Yi Wen and Zhiwei Xu, published in the February 2017 issue of the Economic Journal. Their study indicates how China''s trade imbalances with the United States can persist even in the long run: not because of exchange rate policies but because Chinese workers must save excessively to insure themselves against an unpredictable future.
The researchers show how China''s lack of social safety nets and an efficient banking credit system to channel funds from households to firms can lead to insufficient investment by firms and excessive savings by households, creating a large gap between the rate of return on firms'' fixed capital and the rate of return on households'' safe financial assets (such as bank accounts).
These frictions produce a saving glut among households and excessive demand for capital among firms, explaining China''s low deposit interest rate and high marginal product of capital in recent decades.
In an open economy environment, these differential rates of return to financial and fixed capital mean that household savings opt to flow out of China while foreign investment opts to flow into China, seeking higher rates of returns. This produces the observed phenomenon of two-way capital flows: a large amount of fixed capital flows into China (in the form of FDI) and colossal amounts of financial capital flows out of China (for example, in the form of foreign exchange reserves).
The new analysis sheds light on China''s trade imbalances with the United States and other developed nations. Conventional wisdom attributes China''s persistent and rising trade surplus to its exchange rate policies or undervalued currency.
But such arguments are inconsistent with common-sense economic intuitions. Once trade in both assets and goods are considered in a unified framework with underdeveloped financial markets, persistent trade imbalances can emerge naturally regardless of exchange rate policies.
Think of the following example: suppose the real exchange rate between Chinese-made and American-made products is 1:1 – for example, one Chinese orange for one American apple. When China gives up one orange for one American apple, trade is balanced between the two countries because total Chinese exports (one orange) equal total Chinese imports (one apple) in value.
Suppose the Chinese government is able to manipulate and depreciate the real exchange rate so that Chinese workers must give up 100 oranges for one American apple. Despite the extremely cheap Chinese products with a real exchange rate of 100:1, trade between the two nations is still balanced: the total value of Chinese exports (worth one American apple) still equals the total value of Chinese imports (one American apple). Therefore, trade is always balanced regardless of the exchange rate.
Imbalances of trade (or the current account surplus) would arise in the following situation: suppose Chinese workers gave up 100 oranges for $1, with which they could buy one American apple; but, instead of spending the entire dollar by importing one American apple, Chinese workers bought only half an American apple and kept the remaining 50 cents as savings.
In this case, China would incur a trade surplus of half an American apple, equivalent to lending 50 oranges to American consumers in return for 50 cents as IOUs. But why would Chinese workers do that, tightening their belts and lending to Americans when they are still struggling with a very low level of personal consumption?
The model of incomplete markets and precautionary saving in the new study helps to answer this question. Even though China has experienced impressive economic growth over the past decades since its economic reform and joining the process of globalisation, its financial reform has not kept pace with its economic growth.
Because of the lack of social safety nets and severely underdeveloped insurance and financial markets, Chinese workers must save excessively to insure themselves against idiosyncratic uncertainty or unpredictable events, such as bad income shocks, unemployment risk, accidents and many unexpected spending needs in housing, education, healthcare and so on.
The model predicts that as a consequence of two-way capital flows, the observed large trade imbalances between China and the United States can persist even in the long run.
''Two-Way Capital Flows and Global Imbalances'' by Pengfei Wang, Yi Wen and Zhiwei Xu is published in the February 2017 issue of the Economic Journal. Pengfei Wang is at the Hong Kong University of Science and Technology. Yi Wen is at the Federal Reserve Bank of St. Louis. Zhiwei Xu is at Shanghai Jiao Tong University.
