Global Imbalances and China by Yu Yongding

7/31/2019 Global Imbalances and China by Yu Yongding

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The Australian Economic Review, vol. 40, no. 1, pp. 323

2007 The University of Melbourne, Melbourne Institute of Applied Economic and Social Research

Published by Blackwell Publishing Asia Pty Ltd

1. Introduction

The global economy is suffering from seriousimbalances characterised by a deterioration of

the US current account deficit, rapid increases

in oil and raw material prices and excessive in-

ternational liquidity. At the same time, the Chi-

nese economy is suffering from serious

imbalances of another kind, which is character-

ised by rapid increases in the so-called twin

surpluses (current account and capital account

surpluses), persistence of excessive invest-

ment, acute energy shortages and deterioration

of the environment and the rapid widening of

income gaps, while the economy is growing at

breakneck speed. This article deals with

Chinas adjustment of growth strategy in an en-

vironment of global imbalances. Section 2 pro-

vides a brief account of global imbalances,

especially the US current account deficit and

its causes and possible consequences. Section 3

discusses the causes of the Asian current ac-

count surplus. It is pointed out that there is no

guarantee that Asian economies will continue

to run current account surpluses so as to con-

tinue to finance the US current account deficit.

Section 4 discusses Chinas twin surpluses in

detail and argues that persistently running acurrent account surplus is neither sustainable

nor desirable for China. As a result, correction

will be made by China, no matter what the

United States does with its current account def-

icit. Section 5 discusses policies that have al-ready been adopted or may be adopted by the

Chinese government to address Chinas imbal-

ances. Concluding remarks are presented in the

last section.

2. The Global Imbalances

The Bureau of Economic Analysis of the

United States announced on 14 March 2006

that the US deficit reached 7 per cent of Gross

Domestic Product (GDP) in 2005, with a cur-

rent account deficit of $805 billion, an increase

of $137 billion or 20 per cent over 2004. The

deficit is expected to increase further in the fu-

ture, due to growing consumer demand for im-

ports, and rapid growth in interest payments to

foreign holders of US government securities.

Rapidly rising oil prices and imports explain

about two-thirds of the increase. But US trade

deficits increased with every major region of

the world, including China (34 per cent),

OPEC (18 per cent), Africa (15 per cent), Eu-

rope (15 per cent), Mexico and Canada (13 per

cent combined), Latin America (12 per cent),

and all Asian countries besides China (5 percent). Of course, the largest increase was with

China, from whom the United States does not

import oil (see Scott 2006).

There is nothing new with the US current ac-

count deficit. The United States has run a cur-

rent account deficit for 24 consecutive years,

except for 1990. The rapid increase in the US

current account deficit finally caused alarm in

the second quarter of 2002. As a result, the US

Global Imbalances and China

Yu Yongding*Institute of World Economics and PoliticsChinese Academy of Social Sciences

* This paper is the revised text of the David Finch Memo-

rial Lecture which was delivered at the University of Mel-

bourne on 17 October 2006.


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4 The Australian Economic Review March 2007


dollar began its strategic devaluation. Al-

though the US dollar has fallen 11 per cent

since then, this decline has failed to slow the in-crease in the trade deficit, let alone to correct

the current account deficit. However, to the

surprise of most economists, despite the further

worsening of the current account deficit, the

US dollar appreciated against other major cur-

rencies in 2005. Although starting from early

2006, the US dollar began descending again,

nobody is quite sure whether this will continue,

and what the direction of the development of

the US current account deficit will be in the

near future.

Should we worry about the economic and fi-nancial risks that arise from the US current ac-

count deficit? Canadas current account deficit

averaged 2.5 per cent of GDP between 1975

and 1998; the UK current account deficit aver-

aged 4.1 per cent of GDP between 1984 and

2003; and Australias current account deficit

averaged 4.1 per cent of GDP between 1974

and 2003 (see Royal Bank of Scotland Group

2004). As long as international investors be-

lieve that the deficit countries can provide a

higher or safer return for their investment than

in other places, capital will continue to flow

into those countries to finance their current ac-

count deficits. However, following the accu-

mulation of current account deficits (that is, the

increase in foreign debt), other things being

equal, foreign investors will demand a higher

return for their investment. If the demand is not

met, they may stop financing the current ac-

count deficit. An indefinitely large negative net

international investment position (NIIP) as a

percentage of GDP is inconsistent with long-

run equilibrium. So, the key questions are as

follows. What is the trajectory of the US NIIP

GDP ratio? Beyond what level of the NIIP as apercentage of GDP will the NIIP no longer be

sustainable and hence a correction of the cur-

rent account deficit occur?

In historical terms:

Australias negative net investment position

reached 60 percent of GDP in the mid-1990s, Ire-

lands exceeded 70 percent in the 1980s, and New

Zealand accumulated a position amounting to

nearly 90 percent of GDP in the late 1990s. Nota-

bly, these economies have recently been among

the most successfulin terms of economic

growthin the industrialized world.

[Poole 2005]

Since the later 1980s, as a result of the accumu-

lation of current account deficits, the US NIIP

GDP ratio has been increasing steadily, and by

the end of 2005, it reached 25 per cent of US

GDP. The trajectory of the NIIPGDP ratio canbe depicted by a simple differential equation:

z

= + C

1

e

nt

(1)

where z

is the NIIPGDP ratio, ca

is the CA

(current account deficit)GDP ratio, and n

is

the growth rate of GDP. According to a simu-

lation made by one of my students (Sheng

2005), assume that, starting from 2003, we

have the following initial conditions: t

= 0,

NIIPGDPz

(0) = 24.09 per cent, ca = constant

= 4.82 per cent, and the nominal growth rate of

GDP = constant = 4.9 per cent. The corre-

sponding specific solution is (Sheng 2005):

f

= 0.98 0.74

e

0.049

t

(2)

From the above equation, two conclusions

can be drawn. First, other things being equal,

the US NIIPGDP ratio will stabilise at a level

something like 80 per cent. The steady state is

decided by the current account deficitGDP

ratio divided by the growth rate of nominal

GDP. Second, there is still a long way to go for

the NIIPGDP ratio to reach the steady state(Table 1). The real problem is whether the ex-

ternal finance will be forthcoming, while the

NIIPGDP ratio is on its way to the steady

ca

n------

Table 1 A Simulation of the US NIIPGDP Ratio, 20032010

2003 2004 2005 2006 2007 2008 2009 2010

Years passed 0 1 2 3 4 5 6 7

NIIPGDP ratio (per cent) 24.09 27.54 30.91 34.12 37.17 40.08 42.85 45.49

Source

: Sheng (2005).


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Yu: Global Imbalances and China 5


state. Nobody seems quite sure about the an-

swer. It is likely that at a certain level, before

the NIIPGDP ratio has reached the steadystate, foreign investors will stop financing the

US current account deficit so as to trigger a

dramatic correction.

It seems that whether the rest of the world

will continue to finance the US current account

deficit is an equally important issue to whether

the United States will reduce its investment-

saving gap and take firm actions to reduce its

current account deficit. The sources of capital

inflows to the United States have been EastAsiaJapan and China in particularoil-

exporting countries and some other parts of the

world. According to Bernanke (2005), the

cause of the US current account deficit is the

saving glut in the rest of world. No matter

whether this argument holds water, the sus-

tainability of the US current account deficit

Table 2 Global Current Account Balances, 1996, 2000 and 2004

(US$billion)

Countries 1996 2000 2004

Industrial 41.5 331.4 400.3

United States 120.2 413.4 665.9

Japan 65.7 119.6 171.8

Euro area

a

78.5 71.7 53.0

France 20.5 18.3 5.1

Germany 14.1 29.3 104.3

Italy 39.6 5.7 13.7

Spain 0.5 19.3 49.4

Other 17.5 34.2 40.8

Australia 15.8 15.4 39.6

Canada 3.4 19.6 25.9

Switzerland

b

21.3 30.6 46.0

United Kingdom 10.8 36.2 46.9

Developing

b

90.4 131.2 326.4

Asia

b

40.6 86.8 179.5

China

b

7.2 20.5 55.5

Hong Kong 2.6 7.1 16.0

Korea 23.1 12.3 27.6

Taiwan 10.9 8.9 19.0

Thailand 14.4 9.3 7.3

Latin America

b

39.4 47.9 8.5

Argentina 6.8 9.0 3.0Brazil 23.2 24.2 11.7

Mexico 2.5 18.5 8.6

Middle East and Africa

b

1.1 74.5 116.4

Europe and the former Soviet Union

b

13.5 16.8 12.0

Statistical discrepancy 48.9 200.2 73.9

Notes

: (a) Figures for 2000 and 2004 are taken from the European Central Banks Monthly Bulletin

(various issues) and

converted to dollars. The figure for 1996 is calculated as the sum of the member country current accounts.

(b) The figure for 2004 is taken from the International Monetary Funds World Economic Outlook

(April 2005).

Source

: Bernanke (2005).


4/21



depends on the availability and sustainability

of foreign capital inflows into the United States

(Table 2).It can be seen that the bulk of the increase in

the US current account deficit was balanced by

changes in the current account positions of de-

veloping countries. Among these developing

countries, China was the most important, ac-

counting for a sixth of the total. Developed

countries made similar contributions. The oil

exporters, notably the Middle East but also

countries such as Russia, Nigeria and Venezu-

ela, constituted the third group of important

capital-exporting countries (Bernanke 2005).

Will the saving glut in these three groups ofcountries continue? Will the excess savings of

these three groups of countries continue to flow

into the United States? China aside, East Asian

emerging economies saving glut and current

account surpluses are related to the aftermath

of the Asian financial crisis. With regard to

East Asian countries (excluding Japans) cur-

rent account surpluses, a more detailed discus-

sion will be given in the next section. It will be

shown that these surpluses are likely to disap-

pear in the near future. Developed countries,

especially Japans and Germanys, saving glut

is attributable to aging populations, which

must make provision for an impending sharp

increase in the number of retirees relative to the

number of workers (Bernanke 2005, p. 5). It

seems that as long as the United States can

maintain a relatively fast rate of productivity

growth and hence a higher interest rate, capital

from developed countries that are ageing will

continue to flow into the United States, until

the dependency ratios have become so high

that the saving rates have to drop significantly.

In other words, Japans and Germanys current

account surpluses may last longer than those ofEast Asian emerging economies. Oil-exporting

countries current account surpluses are more

likely to be temporary. When oil prices drop,

the current account surpluses will drop. Over

the past three decades, we have seen many such

ups and downs. Furthermore, for some coun-

tries, such as Arabic countries, the United

States will no longer be a safe haven for their

oil money and they may find other places to in-

vest their oil revenues.

For many US economists as well as govern-

ment officials, the real danger does not lie in

the US current account deficit per se, but in theperception of the deficit. Hence, for the United

States, the foremost danger perhaps is the pos-

sibility that owing to the waning confidence in

the sustainability of the US current account

deficit, Asian central banks will diversify their

foreign reserves away from the dollar assets in

a disorderly manner. The direct consequence of

the increase in the US current account deficit is

largely psychological.

The larger the current account deficit becomes,

the greater the number of observers who believe

that a correction, and one with significant impli-

cations for the U.S. economy, is imminent. Such

expectations have contributed to, and in turn have

been reinforced by, the slide in the dollar over the

past few years.

[Ferguson 2005]

For these US officials and economists, a dra-

matic correction of the US current account def-

icit is not only unwarranted but also unlikely.

For the United States, unlike almost every other

country in the world, a hard-landing process is

inherently self-limiting. U.S. assets owned byinternational investors are predominantly denom-

inated in dollars and a large fraction of U.S. assets

held abroad are denominated in foreign curren-

cies. Dollar depreciation, should it occur in a

hard-landing process, will be self-limiting be-

cause the dollar value of U.S. assets abroad will

rise, thus improving the U.S. net international in-

vestment position. Market participants, knowing

this fact, are therefore unlikely to drive down the

foreign currency value of the dollar in a rapid and

disruptive fashion.

[Poole 2005]

As a matter of fact, after the breakdown ofthe Bretton Woods system, a dramatic fall in

the US dollar occurred several times in the

middle of the 1980s and 1990s, as well as

smaller falls. It is likely that East Asian coun-

tries may no longer wish to continue to run

current account surpluses and accumulate more

foreign exchange reserves in the form of trea-

sury bills and other US assets. It has become in-

creasingly obvious that a further increase in

their foreign exchange reserves means further


5/21



1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004-30000

-20000

-10000

0

10000

20000

30000

40000

50000 Current account

Capital account

1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

-20000

-15000

-10000

-5000

0

5000

10000

15000

20000

25000Current account

Capital account

losses in their national welfare. Faced with a

sort of prisoners dilemma, a free fall of the US

dollar, due to coordination failure, cannot beruled out entirely.

3. Why Asian Countries Run Current

Account Surpluses

From a very interesting perspective, Dooley,

Folkerts-Landau and Garber (hereafter DFG)

put forward a theory arguing that, in the next

decade or two, Asian countries will continue to

finance the US current account deficit happily,

because Asian countries need to run trade sur-pluses against the United States so as to solve

their employment problems. According to

DFG (2003):

In the Bretton Woods system of the 1950s, the

US was the center region with essentially un-

controlled capital and goods markets. Europe

and Japan, whose capital had been destroyed by

the war, constituted the emerging periphery. The

Source

: International Monetary Fund (2006).

Figure 1 Koreas Current and Capital Accounts

US$million

Year

Figure 2 Thailands Current and Capital Accounts

US$million

Year

Source



6/21



1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004-10000

-5000

0

5000

10000

15000

20000 Current account

Capital account

1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

-15000

-10000

-5000

0

5000

10000


Capital account

periphery countries chose a development strat-

egy of undervalued currencies, controls on capi-

tal flows and trade, reserve accumulation, andthe use of the center region as a financial inter-

mediary that lent credibility to their own finan-

cial systems. In turn, the US lent long term to

the periphery, generally through FDI Now

the Asian periphery has reached a similar

weight

Is this what has been happening in Asia? Facts

speak for themselves. Let us check the dynam-

ics of the current account balances of the major

Asian economies.

The first fact is that East Asian countries didnot chronically run current account surpluses.

The US current account deficit has a history of

more than two decades. In contrast, the Asian

current account surplus is a relatively new phe-

nomenon. Although East Asian countries have

high savings, the propensity for investment in

these countries is even higher. All four finan-

cial crisis-affected countries (Korea, Thailand,

Figure 4 Indonesias Current and Capital Accounts

US$million

Year

Source


Figure 3 Malaysias Current and Capital Accounts

US$million

Year

Source



7/21



1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005

-150

-100

-50

0

50

100

150

200Current account

Capital account

Malaysia and Indonesia) ran big current ac-

count deficits for a long time before the Asian

financial crisis. Only after the Asian financialcrisis have all these four countries begun to run

current account surpluses (see Figures 1, 2, 3

and 4). It is obvious that the saving glut is

both a cause and effect of the increase in

the current account surpluses. Crisis-affected

Asian countries were forced to run twin sur-

pluses (capital account and current account sur-

pluses) after the financial crisis to build up their

foreign exchange reserves. The current account

surpluses in these economies are achieved by

significant devaluation and tight monetary and

fiscal policies. There is nothing inherent inthese economies that predetermines that these

countries must run current account surpluses. It

is highly unlikely that these countries will con-

tinue to build up their foreign exchange re-

serves, after the reserves have reached a certain

level or a proportion of GDP. What has hap-

pened in Thailand recently is a case in point

(Figure 2). In short, it is difficult to draw a firm

conclusion on whether the saving glut of East

Asian economies will persist and whether the

United States will continue to be the only recip-

ient of these surplus funds.

The second fact is that Japanthe most im-

portant surplus country in Asiais an outlier

in Asia. It is an advanced country; it has run a

current account surplus every year since the

early 1980s (Figure 5), no matter what has

happened to the Japanese economy. In 2004,while Chinas current account surplus ac-

counted for 20 per cent of the US current ac-

count deficit with Asia, Japan accounted for 48

per cent.

1

Certainly, the DFG hypothesis is ir-

relevant to Japan. Hence, at least a half of the

Asian current account surplus against the

United States is left unexplained by the DFG

theory. I believe that the current account sur-

plus is more intrinsic in nature in Japan than in

any other Asian country. Following the recov-

ery of the Japanese economy, the Japanese

trade surplus may reoccupy the central stage inthe US current account deficit fray in the near

future.

The third fact is that Chinas running of a

large trade surplus is a relatively new phenom-

enon. While Japan has been running a trade

surplus of more than US$100 billion since the

early 1990s, China ran a small trade account

surplus, averaging US$10 billion annually.

Chinas trade surplus peaked in 1997, surpass-

ing US$30 billion. After the Asian financial

crisis, it fell back conspicuously. Before late

2002, the renminbis (RMBs) overvaluation

rather than undervaluation was the mot du jour

.

Chinas trade account surplus has surged since

2003. It surpassed US$102 billion in 2005.

Figure 5 Japans Current and Capital Accounts

US$billion

Year

Source



8/21



However, few people in China are sure

whether Chinas current account surplus is a

long-term phenomenon, and even fewer peopleare sure whether running a large current ac-

count surplus is desirable for China. In fact, ac-

cording to the eleventh five-year program

formulated by the National Reform and Devel-

opment Commission, formerly the State Plan-

ning Commission, in the next five years,

Chinas aim is to run a basically balanced

current account.

Based on the above observations, it can be

said that the DFG hypothesis is too simplistic

and the generalisation is too hasty. There is

nothing intrinsic that will guarantee that Asiancountries will continuously finance the US cur-

rent account deficit by running current account

surpluses. Of course, there may be exceptions,

among the exceptional economiesJapan

rather than China is the most obvious candi-

date.

4. Chinas Twin Surpluses

It is assumed in development economics that

developing countries should run current ac-

count deficits and capital account surpluses, so

as to utilise foreign saving to obtain an invest-

ment rate higher than their domestic saving ratecan support (see Figure 6).

In Figure 6, the vertical axis and horizontal

axis represent resources (domestic saving and

domestic investment) and the period of devel-

opment; II is investment; SS is savings; BR is

the trade deficit; BB is the current account def-

icit (old definition); and BD is the foreign debt

balance.

A developing country that borrows from

abroad should first run a trade deficit and cur-

rent account deficit (in periods I and II). After

becoming a matured country, it will reduce itsdebt liability (in period III). Finally, it becomes

a country with a positive NIIP (in period IV).

However, China has a very different pattern

of international balance of payments. Although

as a developing country, with a very large cap-

ital account surplus for every year since the

early 1980s,

2

China started running a current

account surplus consistently since the early

1990s (Figure 7). The persistent twin sur-

pluses have resulted in the continuous increase

in foreign exchange reserves. In the next

Figure 6 The Four-Stage Development of the International Balance of Payments

Note

: This graph is about debt finance rather than FDI.

Source

: Thirlwall (1983).

D

I

S

B

O X Y Z

RB

I II III IV

S

I


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1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004

-20000

0

20000

40000

60000

80000

100000


Capital account

month, China will become the largest foreign

exchange reserve holding country in the world;

by the end of 2006, its foreign exchange re-serve will surpass US$1 trillion.

In the past, the main contributor to Chinas

accumulation of foreign exchange reserves was

the capital account surplus, more precisely, for-

eign direct investment (FDI) inflows. How-

ever, since 2005, the current account surplus

has superseded FDI to become a more impor-

tant contributor to the increase in the foreign

exchange reserves.

The twin surpluses imply that though China

has obtained foreign funds through FDI, the

funds thus obtained have failed to be used tobuy foreign capital goods, technology or man-

agerial skills. In fact, the funds have flown

back to the US government bond market, and

no real resources have been utilised by China.

As a current account surplus country, China not

only fails to utilise foreign resources but also

fails to utilise a part of domestic savings. In

fact, China has long been a capital-exporting

rather than importing country. In 2005, China

was the third largest capital-exporting country

in the world, while at the same time its per cap-

ita income ranked 138th in the world.

To analyse the nature of the twin surpluses

more carefully, we can use the following iden-

tity:

3

Household savings of residents

+ government

savings

+ reinvested profit

+ investment

income

= investment by domestic enterprises

+government investment

+ reinvested profit

+

new FDI

+ trade surplus

(3)

Based on the above accounting identity, we

have (Yu and Qin 2006):

(

I

e

S

p

) + (

I

g

S

g

) + (

I

f

CA

) = 0 (4)

where I

e

,

I

g

, I

f

,

S

p

, S

g

and CA

represent

domestic private (non-governmental) invest-

ment, government investment, FDI, domestic

private savings, government savings, and thecurrent account deficit, respectively. In the fol-

lowing discussions, we assume away the dis-

tinction between the government sector and the

private sector. Hence, for a typical developing

country, under ideal conditions, there should

be:

I

f

CA = 0 (5)

The above equation implies that FDI is fi-

nanced by foreign savings. The utilisation of

foreign savings is reflected by the existence of

the current account deficit

.

After rearrangement of equation (4), we

have:

Figure 7 Chinas Current and Capital Accounts

US$million

Year

Source



10/21



1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003

30

32

34

36

38

40

42

44

46

48Gross national saving rate

Investment rate

(

S

e

I

e

) + (

S

g

I

g

) =I

f

CA

(6)

Because China fails to translate FDI into thecurrent account deficit, I

f

not only represents

FDI but also the amount of the increase in for-

eign exchange reserves in the form of US trea-

sury bills;

CA

is the current account surplus,

representing another portion of the increase in

foreign exchange reserves that is created by the

surplus. The above identity (6) implies that

while foreign investors obtain equity assetsI

f

,

the hosting country obtains an equal amount of

foreign debt assets (treasury bonds). This is

why we say that foreign funds obtained

through FDI have flown back to the US bondmarkets.

It can be seen that ifI

f

CA > 0, the hosting

country is accumulating foreign exchange re-

serves. In contrast, ifI

f

CA < 0, the hosting

country is depleting foreign exchange reserves.

In China,I

f

> 0,

CA

> 0 and henceI

f

CA > 0.

This is what is meant by the twin surpluses.

Under normal conditions, twin surpluses as a

pattern of international balance of payments are

abnormal and should not exist persistently. In

fact, in history, there is no country in the world

like China that has run twin surpluses persis-

tently for more than one and a half decades.

The first question to be asked is whether this

pattern is beneficial to China. This question can

be discussed within the framework of dynamic

optimisation at another time. Here we only re-

write equation (4) as:

I

e+I

f

= S+ CA (7)

where Sis domestic saving and here the gov-

ernment sector is assumed away.

Based on the above equation, there are sev-

eral cases that are worth discussing. The first

case is when the current account deficit is zero

and domestic savings are initially equal to

planned domestic investment, which implies

that the economy is initially operating at full

capacity. In this case, the increase in FDImeans domestic investment is crowded out.

Because the current account deficit is zero, at

final analysis, FDI is financed by domestic sav-

ings. The second case is when the current ac-

count deficit is zero and domestic savings are

initially greater than domestic investment,

which means that the economy is initially oper-

ating below capacity and there is no crowding

out. But in this case, FDI is also actually fi-

nanced by domestic savings.4 The third case is

when the current account is in surplus. In this

case, after having financed FDI, the remaining

excess domestic savings are used to buy US

treasury bills. In any of the above three cases,

FDI has failed to be translated into the current

Figure 8 Chinas Saving and Investment Rates

Per cent

Year

of GDP

Source: National Statistics Bureau (2005).


11/21



account deficit and ends up as an increase in

foreign exchange reserves.

In developing countries, it is assumed, theprofitability of investment is much higher than

the yield of treasury bills. As pointed out by the

late Professor Rudi Dornbusch, it is certainly

not reasonable for residents of poor countries

to buy US treasury bills in preference to invest-

ing resources in their own countries so as to

raise their productivity and standard of living

(see Dornbusch and Helmers 1988). William-

son (1995, p. 8) pointed out that, [t]he strate-

gic decision is whether to allow the capital

inflow to be translated into a current account

deficit so as to finance increased domestic in-vestment and/or consumption. Therefore, by

running a current account surplus, a developing

country is misallocating resources. Running a

large capital account surplus while running a

current account surplus is a misallocation of re-

sources. It is obvious that twin surpluses mean

a double misallocation of resources. Then why

does China as a developing country run a large

current account surplus and why does China

with excess savings attract so much FDI?

The first and most popular explanation for

Chinas current account surplus is the saving-

investment gap. In contrast to the United

States, while Chinas investment rate is very

high, its saving rate is even higher. Especially

after the mid-1990s, Chinas saving rate has

become persistently higher than its investment

rate (Figure 8).

It seems that there is a strong correlation orco-movement between current account sur-

pluses and the saving-investment gap (see

Feldstein 1983). However, it is still not that

easy to decide whether the saving-investment

gap is the cause or effect of the current account

surplus in China. If the saving-investment gap

is indeed the cause, and the saving-investment

gap is structural, Chinas current account sur-

plus will not disappear any time soon. How-

ever, we cannot rule out the possibility that, to

a certain extent, the current account surplus has

led to the occurrence of the saving-investmentgap. For example, the export promotion policy

has definitely impacted on households saving

behaviour and has made them less willing to

spend money on imported consumer goods and

travel abroad.

The second possible explanation is the eco-

nomic cycles, global as well as domestic.

China tends to run a current account surplus (or

bigger surplus) when the economy is weak, and

a deficit when the economy is overheating. In

China, not only imports but exports also are

sensitive to the growth of the domestic econ-

omy. When the economy was overheating,

growth of exports tended to fall, because more

products were used for domestic consumption.

Chinas current account deficit in 1993, the

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

0

100

200

300

400

500

600

700

800

900

-400

-300

-200

-100

0

100

200

300Exports Imports

Growth in trade balance

Figure 9 Chinas Exports, Imports and the Growth Rate of Net Exports

US$billion

Year

Source: National Statistics Bureau (2005).

Per cent


12/21



only one since 1990, obviously was a result of

overheating. In 1993, the growth rate of GDP

was 14 per cent and that of fixed assets invest-ment was 61.8 per cent. Since 1997, China en-

tered a period of deflation. As a result, demand

for imports was weak until the turn of the cen-

tury. However, during roughly the same pe-

riod, due to the Asian financial crisis and its

aftermath, demand for Chinas exports was

also weak. Hence, during this period, Chinas

current account surplus was not big and the

growth rate of net exports was low (Figure 9).

In 2005, owing to overcapacity in China and

strong growth of the world economy, Chinas

running of a large current account deficit wasquite natural.

The third factor contributing to Chinas cur-

rent account surplus is the governments export

promotion policy, which includes the so-called

self-balancing regulation, exchange rate policy

and tax rebate. In the early stages of reform and

opening up, the main concern of the govern-

ment was how to avoid a balance of payments

crisis caused by excessive borrowings and per-

sistent trade deficits. Therefore, the govern-

ment demanded foreign investors guarantee the

self-balancing of foreign exchange for impor-

tant foreign investment projects. In other

words, FDI must be export-oriented. As a re-

sult, while FDI was introduced, corresponding

trade deficits were minimised.5 It is also unde-

niable that Chinas exchange rate policy is con-

ducive to its trade surplus and current account

surplus. Before the Asian financial crisis,

Chinas exchange rate policy was characterised

by the real targeting approach (Zhang 2003).

The exchange rate was set according to the pro-

duction costs of exports with the aim of main-

taining the competitiveness of exports. During

the Asian financial crisis, RMB was pegged tothe US dollar. The peg was dropped in July

2005. However, the exchange rates influence

on the current account should not be exagger-

ated. In 1997, in support of the Chinese govern-

ments policy of no devaluation, I pointed out

that Chinese exports foreign content was as

high as 57 percent, the competitive edge

achieved by devaluation would be offset imme-

diately to a large extent by the price increases

in foreign inputs of export goods (see Yu

2000, p. 5). The same logic may also be appli-

cable to RMB appreciation. Besides a rela-

tively weak currency, the tax rebate is anothervery important policy instrument. When the tax

rebate rates are correctly calculated, they do

not constitute subsidies. However, in practice,

the policy is full of flaws. Many enterprises ex-

port just to obtain tax rebates. Tax rebate-

related frauds are rampant.

The fourth factor is Chinas position in the

global division of labour. Until quite recently,

the economic relationship in East Asia was

characterised by the so-called flock formation

of flying wild geese pattern. Based on the ver-

tical division of labour, products and capitalflow in and out across borders in the flying

geese formation. Generally speaking, the fly-

ing geese formation would not necessarily lead

a country in the formation to running a current

account surplus or deficit, though most East

Asian economies ran current account deficits

against Japan which led the formation.

In the later 1980s, a new pattern of the re-

gional division of labour began to take shape.

The lowering of communication and transpor-

tation costs, and the liberalisation of trade and

investment regimes, enabled corporations to

fragment and internalise the production process

(Ando and Kimura 2003) and made distance a

less important factor in their location deci-

sion. The clustering effect reduced the impor-

tance of comparative advantage, but increased

the importance of agglomeration in choosing a

production location. As a result of the develop-

ment of international production networks,

processing trade became the dominant form of

trade among less-developed countries.

Chinas current account surplus coincided

with the formation of international production

networks, and its trade pattern was shaped to alarge extent by FDI that flowed in as vehicles

of the formation of international production

networks. The pattern of FDI inflows to China

was in turn facilitated by the Chinese govern-

ments policy in favour of processing trade,

which was motivated by the Chinese govern-

ments fear of a current account deficit and its

desire to allow Chinas comparative advantage

in labour-intensive products to have full play.

Because of the increasingly important role


13/21



played by multinationals from developed coun-

tries, and Taiwanese Original Equipment Man-

ufacturer firms, the bulk of FDI flowed intomanufacturing sectors, such as electronics, au-

tomobiles, family appliances, office machines,

measuring and checking instruments, telecom-

munications equipment, pharmaceuticals and

chemicals. These products were more closely

related to international production networks.

As a result of changes in the regional and sec-

toral distribution of FDI, China was more and

more deeply locked into the international pro-

duction networks and became a processor and

assembler in these networks. While Chinas

trade has expanded with accelerating speed, itis increasingly being dominated by processing

trade. The domination of processing trade in

Chinas trade means that it must run a current

account surplus. As a matter of fact, in 2005,

Chinas total trade surpassed US$1 trillion, and

accounted for more than 70 per cent of GDP.

At the same time, processing trade accounted

for 54.6 per cent of Chinas total exports of

US$762 billion, and foreign-funded enter-

prises (FFEs) share in processing trade ac-

counted for more than 80 per cent of the

exports (Business Watch Weekly 2006, p. 40).

China had a US$102 billion trade surplus of

which US$57 billion was created by FFEs

(China Customs Office 2006), and US$140 bil-

lion was created by processing trade (which

means that Chinas general trade ran a deficit

of US$38 billion).

In the sense that China has established itself

as a processor and assembler in the value-chain

of international production networks, its cur-

rent account surplus is structural and cannot be

changed in a short period of time. After

Chinas WTO entry, FDI from multinationals

has increasingly been concentrated in capital-intensive heavy chemistry, large-scale infra-

structure, high technological industry and the

service industry, which are less international

production network-related. At the same time,

multinationals are increasingly more interested

in Chinas domestic market rather than using

China as a platform for re-export. However,

these new developments may not be able to

change the dominant position of processing

trade in China in the near future.

In summary, four factors have been identi-

fied as possible causes for Chinas current ac-

count deficit. These four factors are the saving-investment gap, a certain combination of do-

mestic and global cyclical movement, the gov-

ernments trade promotion policy, and Chinas

specific position in the global division of la-

bour, especially its specific position in interna-

tional production networks. Without having

conducted some solid empirical tests, it is dif-

ficult to provide definite answers to the ques-

tion of the relative importance of each of the

four factors. However, it seems that the saving-

investment gap and the domination of process-

ing trade are trend factors. The domestic andexternal macroeconomic situation is cyclical

by definition. The export promotion policy is a

factor of history whose importance will be ta-

pering off, though its consequences will con-

tinue to be felt in years to come.6

According to Corden (2006, pp. 67):

It seems perfectly rational to invest some of the

extra savings abroad given the inefficiency so far

of the financial system in allocating funds as re-

flected in the high volume of non-performing

loans held by the banks. The public sector also has

yet to improve the efficiency of public invest-ment. It seems extremely reasonable therefore to

park a proportion of funds abroad until effi-

ciency in domestic investment allocation im-

proves.

Besides this parking theory, another explana-

tion offered by Corden (2006, p. 7) is the de-

liberate pursuit of export-led growth. In my

view, both explanations are relevant to Chinas

situation and are interrelated. Put simply, the

deliberate pursuit of export-led growth is the

cause of Chinas current account surplus and

the parking, extremely reasonable or not, isa reflection of the inefficiency and hence un-

sustainability of export-led growth. If China

runs a current account surplus only, parking

can be regarded as a second-best solution, be-

cause China does not have the ability either to

translate its current account surplus into a cap-

ital account deficit or to use the funds for do-

mestic investment. In other words, China has to

settle with low-yield but safe treasury bills.

However, Chinas situation is worse than that,


14/21



because it not only runs a current account sur-

plus but also a capital account surplus.

Now let us turn to the question of why, as a

country with excess savings, China has at-

tracted so much FDI.7 It is worth emphasising

that capital inflow is attributable to the opti-

mism of foreign investors about Chinas eco-

nomic prospects. We need to analyse the

impact of capital inflows on Chinas current

account. Assuming that China initially runs a

balanced current account, which implies that

there is neither a saving glut nor a saving short-

age, and further assuming that there is no mar-

ket distortion of any form, one can ask the

following: what will happen if capital flows in-

crease suddenly, owing to the surge of opti-

mism, and what will be its impact on the

current account balance? There are two major

channels via which the surge of capital inflows

can affect the international balance of pay-

ments: the interest rate (Figure 10) and the ex-change rate (Figure 11).

In China, the influences of an increase in

capital inflows through the interest rate channel

can be seen most clearly from the rise in stock

and real estate prices, which means a fall in the

interest rate. The impact on FDI is not that di-

rect and clear-cut, but the end result is the

same. How will the lowering of the interest rate

impact on the current account? The lowering of

the interest rate tends to create or increase the

saving-investment gap and this gap in turn will

lead to a current account deficit. Changes in the

interest rate will equilibrate the demand for and

supply of Chinese assets and at the same time

Chinas international balance of payments will

be balanced, after a series of interactions

among numerous variables, at a corresponding

level, with increases in capital inflows and the

current account deficit.

Now let us check the exchange rate channel.

Under the fixed exchange rate, the amount of

capital inflows will be greater than under the

floating exchange rate. If the interest rate has

played the role of equilibrating international

balance of payments, the end result will be an

increase in the current account deficit as well as

the capital account surplus as described in the

previous case. The only difference is that both

the current account deficit and capital account

surplus are greater.

Under a flexible exchange rate, the surge ofcapital inflows will lead to appreciation of the

RMBthe appreciation will reduce the in-

crease in demand for foreign capital inflows (d

d). Therefore, the appreciation will have a

negative impact on the current account balance.

It can be seen that under a flexible exchange

rate, the exchange rate as well as the interest

rate work to translate capital inflows into a

current account deficit. It seems that if there is

no market distortion of any form, exogenous

A A

Demand

Demand

Supply

P

P

Price of assets

Chinese

Figure 10 Capital Inflow and the Price of Assets

assets d

Demand

Supply

e

e

Exchange rate

Dollar

Figure 11 Capital Inflow and the Exchange Rate

Supply

d d

yuan/dollar


15/21



capital inflows always automatically translate

into a current account deficit. In contrast to the

case of a fixed exchange rate, because there isno market distortion, the magnitudes of both

capital inflows and the current account balance

should be in line with an optimum allocation of

resources.

How can a current account surplus exist side

by side with a capital account surplus? Do the

twin surpluses necessarily mean misallocation?

For each individual transaction, if foreign ex-

change fails to be used to buy foreign goods and

managerial skills, it is certainly a misuse of re-

sources. But is it necessarily so for the combi-

nation of all transactions at a given point intime? Now we can imagine a country that is di-

vided into two parts: a special economic zone

and the rest of the country. The special eco-

nomic zone has entered the second stage of de-

velopmentthat is, the zone has achieved great

export capacity as a result of capital inflows in

the first stage of the development and hence

runs a large current account surpluswhile the

rest of the country is still in the first stage of de-

velopmentthat is, it still needs to build up ex-

port capacity for the future by attracting foreign

capital inflows and hence runs a capital account

deficit. Would it not be natural for the twin sur-

pluses to coexist? For the special economic

zone and the rest of the country, respectively,

there is nothing wrong with their individual

balance of payments. However, for the country

as a whole, there is something wrong. Suppose

the current account surplus of the special eco-

nomic zone is greater than the capital account

deficit of the rest of the country, the current ac-

count surplus of the special economic zone

should be used to finance investment of the rest

of the country. If this is the case, the country as

a whole will run a current account surplus anda capital account deficit. If the special eco-

nomic zones current account surplus is smaller

than the capital account deficit of the rest of the

country, the country as a whole should run a

current account deficit and a capital account

surplus. In short, under any circumstances, in-

evitable or not, the twin surpluses always mean

something has been wrong with resource allo-

cation. The larger the twin surpluses, the more

wrong the resource allocation.8

In the following paragraphs, we specifically

discuss how market distortion or imperfection

has led to excess capital inflows to China,while it has to park its excess domestic sav-

ings abroad as foreign exchange reserves.

First, due to the underdevelopment of the fi-

nancial markets, though there may be excess

savings for the economy as a whole, it is very

difficult for many potential importers of capital

goods to raise funds domestically for imports.

On the other hand, due to the preferential pol-

icy towards FDI, attracting FDI as a way to

raise funds is much easier. Sometimes enter-

prises simply sell their foreign exchange ob-

tained via FDI to the Peoples Bank of China(PBOC), and use RMB to buy capital goods

produced locally. As a result, there are in-

creases in FDI and foreign exchange reserves,

but there are no changes in the current account.

Essentially, Chinas domestic savings often

have to be intermediated by foreign capital

markets for domestic investment.

Second, even if funds can be obtained do-

mestically, due to capital control, it is difficult

for potential importers to convert the RMB

funds into foreign exchange so that foreign

goods can be bought, and hence attracting FDI

is still a better option.

Third, despite the fact that the returns re-

quired on FDI are much higher than the yields

of US treasury bills, FDI is the cheapest form

of foreign capital for the myopic enterprises

and local governments. In other words, under

current governance arrangements, from the

point of view of local governments and indi-

vidual state-owned enterprises, FDI is a free

lunch. Who cares about payments if the pay-

ments are due in five to ten years time? Faced

with excessively lavish concessional condi-

tionslow tax rates, long tax holidays, hiddensubsidies in energy use, lax regulations of en-

vironmental protection, free infrastructure and

low or negative rents on land usewhat more

can foreign investors hope for? So the inter-

ests of local governments in attracting FDI

and foreign investors in investing coincide

perfectly.

Fourth, Chinas fiscal system and institu-

tional arrangements also give local govern-

ments great incentive to attract FDI. FDI is


16/21



indispensable for increasing tax revenues at

local levels. More importantly, FDI attraction

is one of the most important criteria, if not themost important criterion, for good local gov-

ernment performance. It is a common practice

in China that all chief officials at all levels of

government are assigned targets for FDI attrac-

tion. Those who attract the largest amount of

FDI are the most likely candidates for further

promotion. To attract as much FDI as possible

at any cost may not lead to the maximisation of

the long-term welfare of the nation; it certainly

will maximise local governments utility func-

tion with a time horizon of four years.

Fifth, recently, in order to give new impetusto the reform of state-owned enterprises and

commercial banks, the merging and acquisition

of Chinese firms by foreign investors and the

acquirement of shares by international strate-

gic investors in Chinas commercial banks

have been encouraged. Consequently, capital

flows have been attracted and added to the ex-

isting stock of foreign exchange reserves. In

2005 alone, US$32 billion of capital has been

attracted as a result of selling bank shares of in-

ternational strategic investors, even though

China has already piled up more than US$800

billion of foreign exchange reserves, without

knowing how to invest them with a higher re-

turn.

Sixth, the single biggest FDI provider is

Hong Kong and the second largest is the Virgin

Islands. The latter accounted for more than 19

per cent of Chinas total attraction of FDI in

2005. Although difficult to verify, anecdotal

evidence shows that a very large proportion of

Chinas FDI is rent-seeking round-tripping

FDI.

There is no question about the fact that China

needs foreign capital goods in which new tech-nology is embodied. Should China buy these

capital goods or obtain the rights to use these

capital goods via greenfield investment? Or

should there be some limit in inviting FDI? In

an efficient capital market, there should be an

equilibrium state where there is no difference

in costs between buying and acquiring via FDI.

In other words, there should be an optimum

amount of FDI that China should attract, no

more and no less.

5. Chinas Possible Actions in Correcting

Imbalances

As mentioned in the second section, sustain-

ability of global imbalances not only depends

on whether the United States can reduce its cur-

rent account deficit but also on how the rest of

the world, including China, will respond to the

further worsening of the US current account

deficit. Consensus has almost been reached

that the twin surpluses are neither desirable nor

sustainable for China. Therefore, China will

take actions to correct its imbalances. Chinas

future correction undoubtedly will have an im-

portant impact on the global imbalances.First, as already mentioned, persistently run-

ning a current account surplus by a developing

country means a poor country is exporting cap-

ital to finance rich countries consumption and

investment. Indeed, [t]here is a more insidious

connection between the saving postures of

China and the U.S.: Chinese savers are, in ef-

fect, subsidizing the spending binge of Ameri-

can consumers (Roach 2006). According to

some calculations, Chinas subsidies to the

United States by providing cheap goods and

buying treasury bills so as to lower US interest

rates amounted to US$80 billion a year. Unfor-

tunately, Chinas good deeds fail to achieve

much appreciation from the Americans. The

Chinese have long been wondering why. Now

a US scholar has provided an answer. In a short

article, Phillip L. Swagel (2005) of the Ameri-

can Enterprise Institute stated:

why pressure China to revalue? U.S. policy-

makers surely understand the downsides of a yuan

revaluation for the U.S. economy. And they cer-

tainly must realize that their very public campaign

only makes it more difficult for the Chinese to

take action. Could it be that this is the point? Acynic might hope that the push for a Chinese

exchange-rate change is not a response to mis-

guided political pressures, but is instead a devious

attempt to prolong the enormous benefits the

United States derives at Chinas expense from the

fixed dollar-yuan exchange rate. Or perhaps this

is accident, not design. Either way, the adminis-

tration has come up with a brilliant strategy to

keep the good times rolling.9

Very enlightening indeed!


17/21



As already shown, Chinas current account

surplus (and twin surpluses) is achieved under

serious market distortion. For example, thecompetitiveness of energy-intensive export

products is achieved through hidden subsidies

in the form of underpricing of energy re-

sources. The same is true of land-intensive

export products. Many of Chinas export prod-

ucts are produced at the expense of Chinas en-

vironment. Furthermore, following the rapid

increase in Chinas export scale and current ac-

count surplus, Chinas terms of trade is wors-

ening.

Second, the over-dependence on processing

trade for the current account surplus, which inturn is based on Chinas disciplined cheap la-

bour, is risking the Chinese economy being

permanently locked into the lower ladder of the

division of labour. With trade being dominated

by processing trade, Chinas economy can be

very vulnerable to external shocks.

Third, trade frictions will be worsening as a

result of the increase in the current account sur-

plus. Chinas exports are already targeted by

the United States, European Union and many

developing countries, such as Mexico and Bra-

zil. The damage made to Chinas economic

growth by protectionism will be very grave in-

deed.

Last but not least,10 the accumulation of for-

eign exchange reserves, as a result of the twin

surpluses, is making the Chinese economy vul-

nerable to US adjustment. According to some

US economists, the US dollar should further

devalue by 20 to 30 per cent. If that happens,

Chinas losses in its foreign exchange reserves

will be tremendous. The wobbly dollar is spell-

ing big trouble for Asian countries. Among

them, China is the most vulnerable. More than

half of Chinas foreign exchange reserves arein US dollars. As pointed out by some observ-

ers, all policy options for the PBOC are unat-

tractive. If the PBOC does nothing and simply

holds on to the dollars, the losses will increase.

If it buys more to prop up the dollar, it will only

have a bigger version of the same problem in

the future. If, on the contrary, the PBOC diver-

sifies into other currencies, it will drive down

the dollar faster and create greater losses. The

dilemma facing Chinas central bank is not un-

paralleled in history. With such a huge amount

of foreign exchange reserves, it is extremely

difficult for China to protect itself.All this means that Chinas excessive current

account surplus together with its capital ac-

count surplus is a gross misallocation of re-

sources. It is very telling that, in contrast to the

United States, with a large positive NIIP,

Chinas net investment income on NIIP was

negative until 2005.11

Currently, the Chinese economy is suffering

from excessive investment and the economy

has been heating up while facing the possibility

of deflation due to overcapacity in the longer

run. The twin surpluses have compromisedChinas macroeconomic management and are

harbingers of inflation and asset bubbles. Since

the middle of the 1990s, the increase in foreign

exchange reserves has become one of the most

important contributing factors to the increase in

reserve money. In order to control the increase

in reserve money, large-scale open market op-

erations (OMOs) have been carried out to ster-

ilise the increase in reserve money by selling

government bonds held by the PBOC. How-

ever, in just a couple of years since 2002,

owing to the enormous scale of OMOs aimed at

neutralising the expansionary impact of the in-

crease in foreign exchange reserves, the PBOC

sold out all the government bonds it had accu-

mulated as a result of the previous OMOs

aimed at increasing money supply to stimulate

the economy. In 2003, the PBOC was forced to

sell central bank bills to mop up the liquidity.

Due to the enormous scale of increase in for-

eign exchange reserves, in a short period of

three years, the total balance of central bank

bills issued reached about 3 trillion yuan RMB.

In contrast, the total balance of government

bonds was just 3 trillion yuan RMB after 10years issuance. Most of the central bank bills

are short-term bills of three months. One im-

portant question is whether sterilisation can be

implemented unlimitedly. This is a debatable

question. Theoretically speaking, as long as the

interest rates paid by the central bank on its

bills are lower than corresponding interest rates

of US assets, say, the yields of treasury bills,

the central bank should be able to carry on with

full sterilisation infinitely, and hence maintain


18/21



an effective control of the monetary base.

However, there are several obstacles to the

continuation of full sterilisation. One of the ob-stacles is that the continuous purchase of low-

yield central bank bills and the increase in the

share of low-yield assets in the total assets will

worsen commercial banks profitability, which

in turn will create a long-term negative impact

on the fragile banking system. Therefore, faced

with a continuous increase in foreign exchange

reserves, the central bank has to make a choice

among three contradicting objectives: a tight

monetary policy, a healthy financial system

and exchange rate stability. Faced with an ex-

tremely high growth rate of fixed assets invest-ment and a steady increase in the investment

rate, there is no choice for the PBOC but to

tighten monetary policy significantly. At the

same time, comprehensive policy measures

will be taken to reduce the increase in foreign

exchange reserves. This means that the twin

surpluses must be reduced.

On the surface, faced with persistence of the

twin surpluses, sustainability of Chinas bal-

ance of payments is a non-issue. However, the

question of sustainability does exist for China

in the long run, due to Chinas accumulation of

FDI. Following the increase in FDI, investment

income outflows will increase too. If China

fails to utilise foreign capital effectively and to

obtain a decent return on its outbound invest-

ment and lending, it may suffer from a current

account deficit as a result of ballooning of in-

vestment income. To adjust Chinas abnormal

pattern of international balance of payments, so

as to reduce the twin surpluses, comprehensive

measures should be taken, which include mac-

roeconomic policy, trade and FDI policy, deep-

ening of financial reform and capital account

liberalisation. The adjustment will be a longprocess and the adjustment should be imple-

mented with great care.

To reduce the current account surplus, the

saving-investment gap should be reduced. To

narrow the saving-investment gap either con-

sumption or investment should be increased.

Because of Chinas current investment rate al-

ready being too high, the focus should be on in-

creasing consumption. In order to do so,

government expenditures on public goods must

be increased. The major areas of expenditure

increase should be social security, the medical

care system and the education system. Thegovernments recent decision to increase funds

to support rural development will achieve the

result of killing two birds with one stone. Fur-

thermore, government investment in infra-

structure, such as railways, expressways,

airports and harbours, and government-

supported R&D should also be increased. It is

worth noting that the most important source of

high saving is not the household sector but the

enterprise sector. State-owned mega-firms

have parked huge amounts of money in banks.

On the other hand, they have not been requiredto pay dividends to their ownersthe public

for a long period of time. The government

should demand a fair share of dividends and

use these dividends to improve its social secu-

rity system.

Preferential policies towards FDI should be

abolished so that domestic investment and FDI

are given equal treatment in terms of credit ac-

cess, taxation, environmental requirements and

so on. As a result, round-tripping FDI will be

reduced and FDI that is not viable without all

sorts of subsidies will stop flowing into China.

Especially, policies in favour of processing

trade should be adjusted.

Export promotion policy should be abolished

gradually. More money should be spent on

buying more foreign goods, especially strategi-

cally important goods and materials. Of course,

while doing so, international markets should

not be rocked.

Financial reforms should be sped up. Small

and medium sized enterprises should not be

discriminated against. Corporate bond markets

should be developed and stock markets should

be made more effective and less speculative.The reform should be aimed at allowing do-

mestic savings to be channelled effectively to

enterprises so that they will have less need to

attract FDI for the purpose of obtaining credit.

FFEs should be allowed to tap Chinas do-

mestic capital market, so that there will be less

need for new cross-border FDI. The govern-

ment should provide the bulk of the funds nec-

essary for the mergers and acquisitions aimed

at enterprise reorganisations.


19/21



Chinese enterprises should be encouraged to

invest abroad both in the form of greenfield in-

vestments and mergers and acquisitions. How-ever, the outflows should be strictly monitored

by the government.

Capital account liberalisation should be car-

ried out smoothly and in an orderly manner.

However, the completion of financial reform

and the revitalisation of Chinas financial insti-

tutions and banks in particular must precede

the final liberalisation of the capital account,

that is, to make the RMB convertible.

The RMB exchange rate should continue to

appreciate gradually. This is a more efficient

way of correcting Chinas imbalances. How-ever, empirical evidence has shown that the so-

called expenditure-switching effect of nor-

mal exchange rate changes is small in China as

well as in the United States. Due to the domi-

nation of processing trade in China, the effect

of exchange rate changes should be even

smaller. To use the exchange rate change as an

instrument to achieve trade balance might lead

to great exchange rate fluctuation. Abundant

experience also shows that overemphasis on

the importance of exchange rate policy in the

correction of current account imbalances may

not only fail to achieve the goal of correcting

trade imbalances, but also cause tremendous

hardship to the countries concerned. After the

Plaza Accord, despite the dramatic revaluation

of the Japanese yen and the slide of the US dol-

lar, the US trade deficit failed to improve in any

significant way, but succeeded in causing tre-

mendous hardship to the Japanese economy.

However, while recognising the limitation of

exchange rate policy, personally, I am for more

action on the exchange rate front. Current de-

velopment of Chinas domestic economy has

made the adjustment of exchange rate policyeven more urgent.

6. Concluding Remarks

Over the past 26 years, China has achieved tre-

mendous success in reform and opening up.

Now China has become the fourth largest econ-

omy, the third largest trading nation and the

largest foreign exchange reserve holding coun-

try. However, China is facing increasingly se-

rious structural problems. Its investment rate is

approaching 50 per cent of GDP and rising. Its

dependence ratio is approaching 70 per cent ofGDP and rising. Its current account surplus sur-

passed US$102 billion in 2005, and will prob-

ably be higher in 2006. Chinas foreign

exchange reserves have reached US$920 bil-

lion and will surpass the threshold of US$1 tril-

lion very soon. Chinas environment is

deteriorating continuously. Its energy shortage

is acute.

To correct the imbalances, the Chinese gov-

ernment has adopted a comprehensive program

aimed at achieving a more balanced and sus-

tainable growth pattern. Whether Chinas newstrategy for a more balanced and sustainable

growth will be successful is dependent on how

well the Chinese government is able to balance

the short-run necessity for high growth and the

long-run necessity for structural adjustment.

On the one hand, Chinas twin surpluses are a

result of long-term imbalance and the events

which have evolved over the past 26 years. The

pattern of twin surpluses cannot be changed

overnight. On the other hand, caution is not an

excuse for inaction.

Global imbalances are not sustainable in the

sense that imbalances are not in the long-term

interests of Asian countries, and the imbal-

ances should be and will be corrected, no mat-

ter what the US government says and does.

However, a drastic correction is neither inevi-

table nor desirable. The key task faced by gov-

ernments in the world is to coordinate their

policies to guarantee a smooth correction. Oth-

erwise, something unexpected may trigger a

dramatic meltdown of the world economy. At

present, the most undesirable thing for Asian

countries is a panic exit from dollar assets by

the major central banks faced with a prisonersdilemma situation. To achieve an orderly cor-

rection, more international consultation and

coordination are needed.

October 2006

Endnotes

1. Bergsten, Fred, IIE Conference on IMF Re-

form, 17 October 2005.


20/21



2. As an aftermath of the Asian financial crisis,

China ran a capital account deficit in 1998, due

to capital flight.

3. In this identity, we ignore other forms of cap-

ital inflow, which is not that important in China.

4. In this case, there is no crowding out and

again FDI is essentially financed by domestic

savings and the end result is also the increase in

foreign exchange reserves. In this case, due to

the lack of demand, macroeconomic policy

will be taken to stimulate demand and a current

account surplus will be encouraged.

5. This policy was abolished as part of Chinas

commitments for WTO entry in 2001.

6. There are also problems with the current ac-

count statistics. The current account surplus

may have been overestimated in recent years.

7. China also attracted a large amount of indi-

rect investment. But FDI is the dominant form

of capital inflows to China. The question of

why China chooses this form of foreign capital

is a question discussed elsewhere.

8. The only exception is when a country has to

build up foreign exchange reserves after a fi-

nancial or currency crisis.

9. According to Swagel (2005), if Chinas cur-

rency is undervalued by 27 per cent, as some

have claimed, US consumers have been getting

a 27 per cent discount on everything made in

China, while the Chinese have been paying 27

per cent too much for treasury bonds. One

might wonder why the United States is com-

plaining in the first place. Revaluation wouldend the Chinese fire sale. Americans will pay

more for everything from shoes to electronics.

Other global investors will buy up US bonds

the Chinese no longer wantand Americans

might even save a bit morebut the treasury

and the public will have to pay higher interest

rates. A stronger yuan will mean not just a

steeper cost of financing government debt, but

also higher payments for US homeowners on

those frothy interest-only mortgages. And do

not expect US job gains from revaluation.

Chinas undervalued currency has cost jobs,

but they were lost in Malaysia, Honduras, andthe other low-cost countries from which US

clothing and toys will be sourced as Chinese

exports slow.

10. During the 1920s, some of the official hold-

ers of sterling grew nervous about Britains

weak foreign trade performance. Foreign cen-

tral banks were told there was no intention of

abandoning Britains link to gold by the Bank

of England. When the inevitable British deval-

uation came on 2021 September 1931, many

foreign central banks were hit hard and wereblamed for mismanaging their reserves. The

Dutch central banker, Gerard Vissering, re-

signed and eventually killed himself as a result

of the destruction wrought on his institutions

balance sheet by the pounds collapse. See

James (2005).

11. This is related to the appreciation expecta-

tions of the RMB exchange rate.

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Global Imbalances and China by Yu Yongding

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