Asymmetric Financial Developments and Global Economic Imbalances: A Lucus’ Paradox between the U.S.

and China   by Peter C.Y. Chow The City College and Graduate Center City University of New York

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The global financial crisis offered an excellent opportunity to review the chronicle issue of the persistent widening of global imbalances; the chronicle trade deficits in the U.S., the persistent trade surplus in the trade-dependent economies, especially China and emerging Asian economies. The cumulated trade deficits in the U.S., which was mainly financed by the issuance of Treasury bonds, were to a great extent, purchased by the trade surplus countries to become their major foreign exchange reserves. It led to the “Lucus’ Paradox” of having ‘uphill” capital flows from low to high income countries in the past decades and was alleged to aggravate the global financial crisis in 2007-08. While policy –driven surplus reversals need not necessarily slow down the growth of the trade-surplus economies, the neo-mercantilist mindedness still prohibits them from taking proactive policies to correct their external imbalances through currency appreciation. In spite of the pledges of G-20 Leaders made at Pittsburgh Summit, little progress was made in sectoral readjustments in both trade surplus and deficits countries. This study argues that the asymmetrical financial developments between the trade surplus and trade deficit countries generated the unique phenomena of having excessive savings in the major trade surplus countries in China and under savings in the U.S. Among other structural re-adjustments to rebalance the global economy, financial development and upgrading the institutional quality in China and emerging Asian countries as well as re-regulations of financial sector in the U.S. seem to be the first task to rebalance global economy for long term sustainable development.

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Introduction

Citing Greenspan’s “conundrum” and Bernanke “savings glut” theses, Kawai (2010) argued that global payment imbalance, macroeconomic policy mistake and regulatory failure were the three major causes of the global financial crisis.

Feldstein (2008) noted that, prior to 2000, most the current account deficits in the U.S. were financed by private foreign direct investment attracted by the productivity and profitability of the U.S. economy. But, after 2000, the U.S. trade deficits were financed through the issuance of Treasury Bonds, which mainly were purchased and being held as foreign exchange reserves by the central banks in many of the trade surplus countries.

Hence, the “twin deficits” in the U.S. became a chronicle issue which not only undermines the confidence of the U.S. dollar, but also challenges the sustainability the U.S. economy and the international payment system.

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It also led to the “Lucus’ Paradox” of having ‘uphill” capital flows from low to high income countries in the past decades and was alleged to aggravate the global financial crisis in 2007-08. While policy –driven surplus reversals need not necessarily slow down the growth of the trade-surplus economies, the neo-mercantilist mindedness still prohibits them from taking proactive policies to correct their external imbalances through currency appreciation. In spite of the pledges of G-20 Leaders made at Pittsburgh Summit, little progress was made in sectoral readjustments in both trade surplus and deficits countries. This study argues that the asymmetrical financial developments between the trade surplus and trade deficit countries generated the unique phenomena of having excessive savings in the major trade surplus countries in China and under savings in the U.S. Among other structural re-adjustments to rebalance the global economy, financial development and upgrading the institutional quality in China and emerging Asian countries as well as re-regulations of financial sector in the U.S. seem to be the first task to rebalance global economy for long term sustainable development.

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5 Figure 1: Trade Dependency of Japan and the First Tier of the NICs

6Figure 2: Trade Dependency of China and ASEAN-5

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Figure 3: U.S. Trade deficits with Asian Countries as A percentage of Total U.S. Trade Deficit

The study is organized in the following order: Section II illustrates the theoretical underpinning of sector balance in national income account and how sector re-adjustments in the trade surplus and trade deficit countries would reduce the trade imbalance.

Section III cites the IMF study on five major currency appreciations in the trade surplus countries in the post-war era to demonstrate that currency appreciation in the trade surplus countries won’t slow down their economic growth. Nevertheless, the neo-mercantilist mindedness in China and other Asian countries may prohibit them to appreciate their currencies too much.

Section IV addresses the dilemma of rebalancing the global economy by sectoral re-structuring in both the trade surplus and trade deficit countries.

Section V addresses the argument that financial development has strong effects on domestic savings and investment and the resultant effects on the balance of trade account, and points out the issue of asymmetrical financial developments in the trade surplus and trade deficit countries. The final section is for summary and conclusions.

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II.Sector Balance in National Income Identity

To examine the global imbalance, it would be necessary to start with the sectoral balance in the national income identity. Sector imbalance in any economy could be derived from variants of the national income identity equations as shown in equations (1) and (2) below:  

C+I+ G+X-M=GDP ……… (1)C+S +T=GDP ……… (2)

 Where the sum of private consumption ( C) , investment( I) , government spending ( G) and net export ( X-M) are added to the total GDP as indicated in (1), which could be re-written as the sum of consumption , saving ( S) and tax ( T) as indicated in (2) as well.  The macro imbalance can be exemplified by subtracting (2) from (1) to equations get 3A or 3B  (I-S) + (G-T) + (X-M) = 0 (3A) OR  (S-I) = (G-T) + (X-M) (3B)  (X-M) = (S-I) + (T-G) (3C)

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Figure 4: Global Current Account Balances as Percentage of GDP in China, oil-exporting countries, Germany, Japan and Emerging Asia.

Source: Cheung, Furceri and Rusticelli (2010)

Since the study deals with the global imbalance, so the U.S. as the major trade deficit country, and China as the major trade surplus countries are further investigated. Figures 5 and 6 shows the respective balances in current account, government budget and saving –investment gaps of these two countries since 1980.

12Figure 5: Sectoral Balances of National Income Account of the U.S. 1980-2008

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Figure 6: Sectoral Balances of National Income Account of China, 1980-2008

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III.Expenditures Switching Approach through

Surplus Reversal Policies

In general, policy –driven surplus reversals have two-folds; one is the expenditure-switching policy through adjustments of trade sector by currency appreciation. The other is expenditure-enhancing policy through re-adjustment of the macro economy by reducing the national savings, both private (reducing the excessive savings) and public (reducing the budget surplus). While correcting the trade account through currency adjustment is a partial equilibrium approach, the way of reducing national saving is a general equilibrium approach. It could be demonstrated from the right In the World Economic Outlook 2010, the IMF provided empirical analysis of policy adjustment in five major trade surplus economies in the past 50 years; Germany in 1970, The divergent patterns on their respective sector imbalances provide us with a pair of dissimilar cases of global imbalances for further studies in sections III and IV below.

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IMF study (2010) also showed some legacies of trade surplus reversals; that is over reactions to currency appreciation , i.e. mismanagement of macroeconomic policies, such as the “too” easy money and” over” expansionary fiscal policy in Japan and Taiwan after the Plaza Accord led to the boom-bust cycles in real estate and financial assets. The legacies of currency appreciation in Japan and Taiwan were resulted from the fact that monetary and fiscal policies in both countries had more than offset the declining next export through currency appreciation. The drawback of the surplus reversal re-adjustment policies undertaken in Japan and Taiwan offered a wrong lesson for some trade surplus countries and may discourage them to undertake exchange realignment to correct their trade surplus. Moreover, somebody even attributed Japan’s “lost decade” in the 1990’s as a result of the Plaza Accord of currency realignment. Neither argument is valid in post-transition period as shown Figure 7, seen next:

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Figure 7a: Economic Performances in the Post-transition Period after Exchange Rates Appreciations in Germany 1970, Japan in 1973 and 1988, Korea and Taiwan in 1988-89.

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Figure 7b: Economic Performances in the Post-transition Period after Exchange Rates Appreciations in Germany 1970, Japan in 1973 and 1988, Korea and Taiwan in 1988-89.

The following figures further illustrate the cases of Japan following the Plaza Accord in 1985. One can find that Japan’s GDP growth, after the less than one year lag, picked up steadily and had a descent growth rates in the late 1980’s before the “lost decade”.

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Figure 8: Japan’s Economy after the Plaza Accord

The IMF study could provide a convincing lesson for China and other emerging trade surplus countries to restructure their macro imbalance through currency appreciations without hurting their respective economic growth rates. Nevertheless, the neo-mercantilist mindedness in those trade surplus countries still prohibits them from taking any proactive policy actions to correct their external imbalances. Take China for example, the $ 204.3 billion of stimulus package, which accounted for 4.8% of China’s total GDP, didn’t slow down the global imbalance at all; With 85% of China’s stimulus package are government subsidies for public enterprises, at most, one could expect that there will be a rise in public investment to offset a fall in private investment, but not increase total investment in China at all. Moreover, the percentage of private consumption in total GDP in China is about 40%, which is far below most industrialized countries. Therefore, there is plenty room for further expansion of domestic consumption in China to re-structure its macro economy.

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IV. The Dilemmas of Restructuring

in the Trade Deficit Economy

Politically, increasing government expenditures and cutting tax in the trade surplus countries in the trade surplus countries is much easier and less social resistant than fiscal austerity in the trade deficit countries to correct their respective trade imbalances. Socially, reducing the excessive savings by increasing household consumption in the trade surplus countries is also more popular and socially acceptable than reducing private consumption in the trade deficit countries as well. From equation 3 C, one knows that U.S. trade deficits could be reduced by cutting the saving –investment gap and trimming government budget deficit. That means the U.S. has to increase its personal saving and consuming less, and the U.S. government has to reduce its budget deficits. Nether is easy to pursue without political pains.   (S-I) + (T-G) = (X-M) (3C)

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Other than fiscal austerity and more frugality for the American people, there are several dilemmas in restructuring the current account imbalances for the U.S.; first and foremost, the U.S. has been and still is the largest market which imports $ 2 trillions of merchandise trade from the rest of the world.

This is due to the fact that the U.S. and EU accounted for more than 30% of total exports from Asia. Moreover, roughly around 40 to 50% of intra-regional trade in Asia is for re-export to the markets outside the region. Should the American people save more and import less from the rest of the world, especially from Asia, it would be a direct drawback for the recovery of Asian countries whose growth rates are pending on export ( 46% of total Asian GDP ) and 30% of their exports are destined to the U.S. and EU.

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According to Fred Bergsten, for every $1 billion of U.S. export increases, there will be 6,000 to 10,000 more jobs to be created. For agricultural export, it was estimated that $ 1 billion of export will create 9000 jobs. To fulfill President Obama’s plan of creating 2 million jobs, it would require that the U.S to increase its annual exports by $200 Billion to $333 billion in the next five years. The question is where is the market to absorb those exports from the U.S.? Even though the Obama Administration has some policy measures to boost U.S. export such as increase of export loan through the export-import bank, lifting control on export of dual use of high-tech products, the growth of U.S. export, in addition to trade competitiveness, also depends on the world market demand, and its probable impacts on crowding out the existing suppliers from other rival countries.

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The second dilemma is the difficulties of sectoral adjustment in both the U.S. and those trade dependent countries; the sectoral adjustment problem has two different aspects; the first one is U.S. export commodities may not match the domestic demand in those trade dependent countries. Except for the high-tech sectors, much of U.S. export in agricultural commodities and consumer products could hardly penetrate into the markets in those trade dependent countries. Hence, unless the industrial restructure in both the U.S. and those trade dependent countries could be re-adjusted substantially, the prospects for promoting U.S. export are dim, at least, in the foreseeable future.

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The third aspect of re-adjustment dilemma is the mismatch between of supply of and demand for tradable commodities in those trade dependent countries. If the U.S. substantially cut its imports from those trade dependent countries, then those manufactured exports from Japan, China and other trade dependent countries may not be absorbed by their domestic demand and or alternative markets due to different consumption patterns between the U.S. and those exporters; Japan’s aging population may demand more non-tradable goods such as health care rather than those tradable goods such as consumer electronic products and automobiles. Industrial re-structuring usually has a longer time lag than the shifts of macro and trade policies. The Hatoyama government in Japan faced a strong challenge from Japan’s manufacturing industries for not taking enough policy actions to avoid the appreciation of the Japanese yen during his tenure, which had undermined Japan’s export competitiveness amidst the coming rivals from more advanced developing countries such as China, Korea and Taiwan.

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The fourth dilemma is a plausible revival of under -consumption scenario in Keynesian economics in the world economy. Given that the federal deficits in the U.S. need to be trimmed in the next few years to avoid the swollen national debt, if the U.S. consumers truly become more frugal by increasing their savings ratios, how to boost the aggregate demand to avoid another recession? Reportedly, savings ratio as percentage of disposable in the U.S. increased from 4.5% to 4.8% after the financial crisis, still below the historic level of 6%. If American consumers save more and spend less, how to fill up the gap left by the declining personal consumption expenditures and to maintain the momentum of economic recovery?

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V.Asymmetric Financial Developments in the

U.S. and Trade Surplus Emerging Market Economies

The neo-mercantilist mindedness in the trade surplus countries may prohibit them from taking proactive policy actions to correct their current account surplus through currency appreciations; Moreover, there is also a fundamental dilemma of international payment system, i.e. the “structural deficit” dilemma in the key currency country as recognized in the “ Bretton Woods II” thesis ( Dooley et al.2009)

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V.1.

Econometric Models on Global Current Account Balances

This section analyzes the “asymmetric developments “of financial sector between the developed countries with trade deficits and the developing countries with trade surplus to readjust the saving ratios in both groups of countries so to mitigate the current account imbalances of the global economy. It argues that the asymmetric developments of financial sector between the trade deficit and trade surplus countries in the world economy, notably i.e., U.S. and China had led to under saving in the U.S. and excessive saving in China. Hence, not surprisingly, the asymmetrical developments had caused the “Lucus Paradox” (Lucus, 1990) of having the “uphill” capital flows from low income to high income countries in the past two decades under the “Bretton Wood II”. It emphasized that re-structure the financial sector in both the trade surplus and trade deficit countries is less painful and politically more feasible to rebalance the global economy.

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By using panel data for 94 countries from 1973 to 2008, an OECD study conducted by Cheung, Fuceri and Rusticelle (2010) found that the widening global imbalances in the years prior to the financial crisis reflects in part the flows of capitals from emerging countries with excessive savings and under developed financial markets to developed countries with under savings but with more advanced yet under-regulated financial system.

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The approach used by Cheung, Fuceri and Rusticelle (CFR, 2010) is to assess the effect of “structural determinants” on current-account balances (CA) by regressing CA with a set of macroeconomic, financial and institutional variables. Since current account in any country is determined by the behaviors of investment and saving, the factors that would plausibly affect the saving-investment models, notably demographic, income, financial development and quality of regulatory institutions, are included in their model as follows;   CAtt = α + β Xtt + θ Dtt + δ Ftt + γ Ptt + εtt (1)

  Where CA is the current account balance as percentage of GDP, X is a vector of macroeconomic and demographic variables, F is a vector of financial development indicators, and P is a set of institutional variables.

Since current-account balances are relative measures and their movements depend on developments in the rest of the world, all the explanatory variables (with the exception of net foreign assets and dummy variables) are converted into deviations from their GDP-weighted world mean in the CFR model.

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V.2.

Structure of Current-Account Positions

To assess the “structural” factors behind current-account balances, the focus on medium-term trends in all of the variables are estimated via OLS:  (2)  Where are the medium-term trend values of the explanatory variables in equation (1). To approximate these trend values, they used non-overlapping five-year averages of all variables, which allow them to iron out cyclical fluctuations while limiting the possibility of measurement errors.

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For financial development as an explanatory variable, the result in the full sample was significantly negative. The interpretation of the negative relationship between financial development and current account balance varied country by country; it was argued that the negative relationship between financial development and current account balance “may reflect the “bypass effect” of capital flowing from emerging market economies toward countries with more efficient financial institutions and markets”. Therefore, it implies that an improvement of financial market in those countries would lower the need for precautionary savings, hence, to reduce the current-account balances; this is an issue to be further discussed in V 4.

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However, it was also pointed out that for China, the variable of financial development as proxied by private credit/ GDP ratio may not fully reflect the levels of its financial development because much of the data of private credit were provided to state-owned enterprises within the non-government sector. For other countries, the highly developed private credit market may generate excessive household borrowing that lowered private saving. Easy credit condition and excessive borrowing in the industrialized countries experienced the asset price booms. This phenomenon, which is typically exemplified by the sub-prime mortgage in the U.S., may capture the “wealth effect” that has offset the effect of efficient financial market on personal savings.

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Moreover, poor financial regulatory quality in China and lack of social safety nets also boosted the levels of precautionary savings, and self –insurance behavior appeared to dominate financial planning of household in China and emerging Asian countries, especially following the Asian financial crisis.  To specifically identify the factor contributing to current account balance in some major economies with current account imbalances, a decompositions of the contributions from each factor to current account balances in the U.S., China and other Emerging Asian countries are reported in Figures 9 A-C seen next:

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Figure 9 A: Decomposition of Current Account Balances in the U.S.

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Figure 9B : Decomposition of Current Account Balances in China

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Figure 9C : Decomposition of Current Account Balances in Emerging Asia Countries except for China

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V.3.

Decomposition of Medium-Term Current Account Balances under CFR Model

For China, except for the variable of “relative income”, all explanatory variables are positively contributed to its current account surplus. Among them, the regulatory quality and openness have contributed the most to its current account surpluses. While the increasing degree of economic openness is consistent with the trend of globalization, a country could not rely on the backwardness of its institutional quality to maintain its current account surplus forever. Hence, there is substantial room for improvement in China’s institutional quality for its sustainable development.

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China’s case has shown that capital inflows have been more than offset by capital outflows “bypassing” its weak institutions and underdeveloped financial system toward countries perceived to possess more efficient regulatory and financial systems. Essentially, one could argue that, due to lack of financial development, trade surplus countries like China have to invest their assets in some “safe haven” countries. This explains well the ‘up- hill” capital flows of the Lucus Paradox. In fact, Caballero and Krishnamurthy (2009) argued that the demand of riskless assets from the rest of the world “not only triggered a sharp rise in U.S. asset prices, but also exposed the U.S. financial sector to a downturn by concentrating risk onto its balance sheet”. Caballero further provocatively argued that the rest of the world has had “an insatiable demand for safe debt instruments that put an enormous pressure on the U.S. financial system to bridge the “safe –assets gap”. Having advocated the different degrees of risks associated with the asymmetrical financial developments between developed and developing countries, Dooley and Garber (2010) further argued that “a balance of trade in assets create an imbalance of risks for residents in the rich and poor countries” ( p. 51).

An interrelated issue is the degree of financial openness and financial development in Asian countries. Dooley et al (2005) pointed out that in the absence of a well integrated and well –functioning financial market domestically and regionally, East Asia countries, with trade surplus essentially lend their capitals to the U.S. even at a lower interest rate than what they could get from the region.

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Furthermore, the inefficient financial system also boosted the precautionary savings in China and emerging Asian countries; Relatively low social expenditures in government budget in China may have motivated households to maintain high levels of precautionary savings. Under developed credit markets also forced consumers in those countries to save more, rather than financing their purchase of durable goods and housing through consumer and mortgage loans. Restricted mortgage loans with proportionally high down payment requirements also contributed the high saving ratios in those countries. Meanwhile, beyond the demographic factor which contributed positively to China’s current account surplus, Wei and Zhang (2009) argued that increase of household saving rates since the 1990 was attributed by the increasing proportion of male adults resulted from “one child policy”, which motivated greater wealth accumulation to better prepare in the marriage market.

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For the U.S., other than its oil intensity which accounted for large part of its current account deficit, the fiscal deficit, private credit and openness have persistently affected negatively on its current account balances. The relatively advanced financial system in the U.S. made easy credit possible and contributed to the consumption oriented economy with private consumption accounted for 70% of total GDP. Much of the private consumption was financed through consumer credit and made the U.S. itself as the prime recipient of capital flows from emerging economies with excess savings and underdeveloped financial markets.  The highly developed but under-regulated financial industry has fueled the asset prices bubbles and stimulated excessive household borrowing and corresponding declines in saving rates in 2004-2008, on the eve prior to the global financial crisis. Wealth effects have also contributed to external deficits in the country that experienced asset price booms as a result of un-regulated financial industries.

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The above study has some significant policy implications for restructuring the global imbalances; Except for fiscal deficit, none of these structural factors could be re-adjusted in the immediate aftermath of the financial crisis. Even trimming the fiscal deficits is not an easy job politically in the industrial democracies. Reducing trade imbalances through currency appreciation of Renminbi is one approach if China could be convinced by the IMF study showed in Section III. Unfortunately, not only China was not quite ready to adjust its exchange rates, it is also highly politicized by politicians in the U.S. as well. Hence, re-structuring financial sector in China and emerging Asian countries seems to be a more feasible approach to rebalance the global economy for sustainable economic growth in the medium and long term.

It was pointed out by Cheung, Furceri and Rusticelli (2010) that the global imbalances, which were reduced by half between mid-2008 and mid-2009 probably, will reappear after the global economy is recovering from the financial crisis unless structural readjustments are carried out in the near future.

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V.4.

Reexamine the Financial Repression Thesis on Saving-Investment in China

In the study by Ito and Chinn (2007), financial development was measured in terms of the market size, which was defined as the sum of private credit creation and stock market capitalization, both measured as ratios of GDP. It showed that the size of financial market has significant negative effect on current account balance only in industrialized countries, but not in the restricted samples in LDCs (with or without including African countries). However, after adding the indicators of “ activeness” of stock market, “efficiency of financial market” and the interaction terms, then the “ size “ of financial market became a significant factor in determining current accounts in all country groups, with positive effect for industrial countries and negative effect for LDCs ( with or without Africa) and emerging markets ( Table 2. ).It implies that the financial development alone may not be able to fully catch the complexity of the effect of financial sector on current account, but has to be complemented by the stock market activeness, efficiency of financial market, the degree of financial openness and their mutual interactions as well.

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Since China and emerging Asian countries had accounted for more than 60% of the U.S. trade deficit, it is imperative to further the study on saving –investment gap and its impacts on the current account surplus in those Asian countries. Jha, Prasad and Terada-Hagiwara ( JPT hereafter , 2009) examined the sectoral contribution of Asian economic growth first by decomposing the domestic sources, foreign demand and welfare effect and then examined the components of national saving in selected Asian countries ; For all sample countries, the unweighted median growth rate is 5.3% and domestic consumption contributed 3.8% ( 3.6% exclude China) to it. But, in China, Hong Kong and Taiwan, domestic consumption contributed less than half of their GDP growth rates in the 2000-2007 periods. Meanwhile, for most Asian countries, private consumption growth accounted for about three quarters to total growth except for China where government rather than private consumption dominated the domestic consumption as showed in Table XX below.

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For investment, the average contribution growth was at 1.2% percentage point toward the average growth rate of the 5.3% in the region. Nevertheless, China’s investment stood out an outstanding example of much larger shares of 4.5 percentage points toward its 9.8% of average annual growth rate in the 2000-2007 period. In other word, the high growth rate in China was mainly contributed by its high investment rather than private consumption. It further confirms that that there is room for improvement in reducing its current account surplus in China by boosting its private consumption. This approach is more feasible and less political sensitive than the exchange rate appreciation to reduce its trade surplus against the U.S.

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Though the thesis on “financial repression” a la McKinnon was initially referred to the underdevelopment of financial sector in Latin American countries, it could be partly applied to China and emerging Asian countries with some qualifications as well. While most developing Asian economies have got rid of the “vicious circles of saving” and registered a more than 30% of average saving rate since the mid-1980’s, the underdevelopment of their financial sectors, except for Hong Kong and Singapore, could have contributed to the excessive savings and the resultant global imbalances. First of all, one has to ask where do those savings come from? And then to ask where did they dispose their savings?

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The JPT model (2009) found that, among the three sources of domestic saving, i.e. households, corporate, and the government, corporate saving dominated the sources of domestic savings in the region. While savings ratio in total GDP is around 50% in China, corporate saving accounted more than 50% of total domestic savings in 2006. It is a mirror image of China’s state-owned enterprises (SOEs) and policy-induced factors such as government subsidies on energy and land cost, underfunding of company pensions and imperfect capital market. The administrative monopolies in some key sectors of China’s economy plus those distorted policies in factor markets led to high level of profitability for them in the boom period until the 2008 financial crisis. Moreover, it was reported that about half of the listed companies in China paid no dividends, and even for those which paid dividends to their shareholders, most of them went to people in high income bracket with higher propensities to save than would be otherwise. This is one of the fundamental causes of the high saving in China.

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Others studies like Lin ( 2009) and Prasad ( 2009B) cited in the JPT study also argued that high level of corporate saving in China was partly attributed to financial structure dominated by the state-owned banks, an equity market and the repressed financial system. All of these factors are favorable to large SOEs. The state-owned banks probably made loan decisions based more on administrative discretions rather profitability of investment projects undertaken by the SOEs, and squeezed out other investors- a scenario similar to McKinnon thesis of “financial repression”. Those frustrated investors who were discouraged from the repressed financial market in China were led to rely on internal finance by retaining their earnings rather than borrowing from the curb money market as prescribed by McKinnon model on financial repression. That is another reason why more than 50% of total investment in China came from corporate saving, which is insensitive to the changing interest rate. This phenomenon offered a mirror image on the inefficacy of monetary policy as an instrument for stabilization policy as well.

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While household saving behavior is well documented in literature, Asian countries have their own unique factors; among them, precautionary motives are the most important determinant. In the absence of social safety nets, health insurance, educational loans, limited pension coverage and low unemployment compensation funds were identified as the most significant factors for the precautionary savings in China. Much of the precautionary savings could be mitigated if financial institutions and markets in China could be further developed.

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The other factor contributed to precautionary saving in China is the rising housing prices in urban area with limited availability of mortgage loans and high down payment requirement. Without well developed financial market to smooth consumption patterns over the life-cycle in a growing economy, China has encountered the phenomenon of a growing economy with an ever rising ratio in the household saving. Further development of China’s financial markets and institutions could reduce household saving rates by reducing the rate of return risks and easing liquidity constraints through systematic development of consumer credits and mortgage loans. Hence, provision of accessible credit for Chinese consumers would substantially reduce their precautionary savings and encourage them to consume more. This will contribute to the reduction of China’s current account surplus which is much more feasible politically than the appreciation of its currency against the U.S dollar.

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At the present, consumption as percentage of total GDP only accounted for an average of 40% in China. As per capita income increases, it is reasonable to predict the ratio will increase over time as well. Further development of consumer credit and mortgage loan markets should be pushed to support further consumption expenditures on durable goods and housing. This argument is also consistent with the stages theory of economic development (W.W.Rostow, 1971) that there is a trend of increasing consumption along the path of economic development.

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V.5.

Policy Implications: The Role of Financial Development in Readjusting the Global Current Account Imbalances

The export-led, external demand –driven development policies under taken by China and other trade dependent countries, though has its merits in the past decades, need to be readjusted in the aftermath of the global financial economy. The proliferations of regional trading agreement in Asia, if proceeds to lead further intra-regional trade as anticipated, would provide a clue to diversify the export destinations of China and those Asian countries.  On sectoral re-adjustment in the trade surplus and deficit countries, the most significant finding from OECD study (2010) is the asymmetry of financial development between the trade surplus and deficit countries; the widening global imbalance was tandem with the asymmetry of financial development and the over savings through the capital flows from trade surplus countries to the trade deficit country. The phenomenon contributed to the “Lucus Paradox” of capital flows of having the “up-hill” capital movements from poor to rich countries (1990).

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But, the OECD study merely pointed out the fact of asymmetric financial developments in the trade deficit-notably the U.S. and the trade surplus-notably China and emerging Asian economies without dealing with the causality. Moreover, the effect of financial development on saving is not without ambiguity because efficiency of financial market/ institution has both income and substitution effect. Edwards (1996) toke the view that financial deepening would generate more saving due to higher rate of return and lower risk involved in an advanced and sophisticated financial system. McKinnon argued that financial liberalization which leads to higher real rate of interests would further enhance household saving as well. Obviously, McKinnon-Edwards thesis is different from the OECD study that financial development in China would reduce personal savings. Nevertheless, financial development could have both demand side and supply side effect on the saving-investment equation. On the demand side, financial development could channel savings effectively into productive investment rather than buying low-yielding U.S. Treasury Bonds. On the supply side, a more developed financial system could encourage business investment by providing them with the necessary financial capitals. Hence, the net effect of financial development on the saving-investment gap (S-I) is an empirical question pending on the relative effects of financial development on both the saving and investment, not just saving alone.

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It is also noted that there is a contrasting view that a more developed financial system would make credit more readily available and reduced the precautionary demand for saving and the “saving glutting” theses of Bernanke. Ito and Chinn( 2007) found “ that it is unsurprising that China, with a large closed financial market, equipped with a mediocre index of institutional development, is running a large current account surplus” (p.14). Hence, it is reasonable to propose that one feasible approach to correct global external imbalance is through the financial development in China and other the trade surplus countries emerging Asian countries; i.e. the underdevelopment of financial system in China and other emerging Asian economies, which led to the excessive savings in the private sector for precautionary purposes, needs to further develop to undermine their excessive savings when their incomes increase.

One counter argument may cite the high savings ratios in Japan and Singapore and their relatively well developed financial markets and institutions. Yet, Singapore’s mandatory savings through the “ central provident fund” may override its financial development on saving whereas the high housing price and more rigid mortgage lending in Japan may also force the Japanese to save more.

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The other issue is the measurement of financial development in empirical studies. Literature provided us with a handful of indicators of financial development; in addition to the private credit as ratio of GDP, stock market capitalization as a share of GDP, stock market turnover as a share of GDP, the growth rate of stock market capitalization as a share of GDP, private bond market capitalization as a share of GDP, liquid liabilities as a share of GDP, index of financial liberalization and financial openness. Since the indicator of financial development is the ratio of private credit as percentage of GDP in the OECD study and the data from China mixed up with the credits provided with the SOEs affiliated sectors, further study with alternative measurements of financial development in China is needed.

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On the other hand, the advanced financial system and efficient financial institutions which had made easy credit for American people had enabled them not only to finance their housing and consumer durable goods through mortgage loan and credit creation easily, but also facilitated multiple credit expansion through securitization of mortgage loans and financial leverages. In the aftermath of the financial crisis, both financial instruments need to be scrutinized to rebalance the global economy for sustainable development. This argument would echo Feldstein (2008) that “low national saving is the fundamental cause of the U.S. trade deficit”. The financial regulatory bill signed by President Obama is the first step in the correction direction. Yet, more policy incentives for American people to encourage their savings are needed.

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Therefore, to mitigate the global external imbalance, one has to promote financial development to facilitate credit expansion, to enhance the institutional quality, and to increase the social safety nets to reduce the precautionary savings in China and other emerging Asian economies. Specifically, the OECD study ( 2010) pointed out, a few policy distortions in those trade surplus countries need to be removed to reduce the institutional distortions which led to the high corporate savings in China. The excessive savings over and above investments due to the under development of financial markets to finance mortgage, the inadequate retirement pension and safety nest system, and the lack of mechanism of sudden capital flows need to be corrected.

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VI.Conclusion

Global imbalances is a secular, not a cyclical, issue in the world economy. National accounts need not be balanced all the time. Yet, if resulted from distorted regulatory and undeveloped financial sector, it would undercut macroeconomic performances. Structural re-adjustment to correct the global current account imbalance faced critical challenges in both trade deficit and trade surplus countries. The export-led, external demand driven development strategy in China and many emerging Asian countries need to re-direct their market destinations toward more domestic-oriented, intra-regional trade rather than do their businesses as usual in the post-crisis era. Yet, it won’t be accomplished in the short term.

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Currency realignment in China and other trade surplus countries would not necessarily deter their economic growth as the lessons from five major exchange rates appreciations in German, Japan, Korea and Taiwan had shown. Nevertheless, the neo-mercantilist ideology in the trade surplus countries may prohibit them to adopt exchange appreciation policy any time soon.  Demand management policy to shift the inter-sectoral resources in the macro economies may not be feasible politically in the short term. Restructuring macro imbalances by trimming fiscal deficit faces the political difficulties in the trade deficit country, whereas cutting consumption or increasing export may encounter the mismatch of supply and demand in the trade dependent countries. One more feasible method to restructure the global imbalance is to re-examine the role of financial development in savings. The asymmetric financial developments between the trade surplus and deficit countries seem to be an important clue to resolve the global imbalance.

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The “ up -hill” trend of capital flows from trade surplus but lower income countries to trade deficit but high income countries could be reversed by restructuring their respective financial sector for sustainable development; excessive saving in trade surplus country, other than cultural and demographic factors, is due to under development of financial sector, lack of social security net etc. Once financial development in those trade surplus countries has been enhanced and mortgage financing as well as social security nets are more accessible, the need for the precautionary savings will be reduced. By so doing, household consumptions in the trade surplus countries will increase through credit expansion and more efficient financial markets and institutions. Hence, the quality of life will be improved and more people will be benefitted from their high economic growth. With a decreasing saving in both private and public sector in the trade surplus countries, then their current account surplus will be trimmed.

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On the other hand, under saving in the trade deficit countries is due to highly developed bur under-regulated financial market on the speculative funds which need to be checked. Trade deficit economies with advanced financial markets would need to re-regulate its financial institutions, reduce their consumptions by tighter monitor of credit and government budget deficits. The wealth effect of un-regulated financial assets from the speculative hedge fund, which totaled to $ 62 trillion, needs to be scrutinized.  Political feasibility of the policy mixture on demand management to correct global imbalances support the argument that enhancing financial development and institutional quality in the trade deficit countries-notably in China and emerging Asian countries and to re-regulate financial sectors in the U.S. as one of the most feasible tasks to re-balance the global imbalance for sustainable economic growth.

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Appendix

Sectoral Components of National Income Account in the U.S. and China

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Table A:

Sectoral Composition of GDP in the U.S.

Data SeriesGDP GDPA

C PCECAS GSAVEI GPDIAX EXPGSAM IMPGSAG AFEXPNDT AFRECPT

The US data are from the St. Louis Federal Reserve’s FRED database.

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Year S/GDP C/GDP I/GDP G/GDP T/GDP (X-M)/GDP (S-I)/GDP (T-G)/GDP

1980 20.97127 62.97479 17.19092 21.14343 19.10979 -0.46627 3.780352 -2.03364

1981 21.43086 62.02827 18.30626 21.64193 19.82538 -0.40297 3.1246 -1.81655

1982 17.29067 63.79872 15.89819 23.13414 18.97824 -0.61478 1.392475 -4.15591

1983 18.26232 64.74849 15.96503 23.18508 18.20008 -1.45985 2.29729 -4.98501

1984 19.60874 63.62665 18.71327 22.42489 18.06202 -2.61263 0.895469 -4.36287

1985 17.3278 64.43628 17.45584 22.59632 18.36159 -2.73148 -0.12804 -4.23474

1986 15.50189 64.94697 16.73729 22.66093 18.29555 -2.97303 -1.2354 -4.36537

1987 17.811 65.38721 16.57377 22.08217 18.92788 -3.05929 1.237227 -3.15429

1988 18.22798 65.68308 16.10854 21.50616 18.79264 -2.15865 2.119442 -2.71351

1989 16.3897 65.56794 15.95921 21.37867 18.93435 -1.6034 0.430492 -2.44432

1990 15.74347 66.12361 14.84355 21.70847 18.66736 -1.33782 0.899922 -3.04112

1991 15.72737 66.42246 13.39931 22.03401 18.38921 -0.44892 2.328065 -3.6448

1992 14.44429 66.80384 13.63543 22.87025 18.10069 -0.51716 0.808855 -4.76956

1993 14.80337 67.2466 14.29793 22.56202 18.35948 -0.96589 0.505444 -4.20254

1994 16.08705 67.05245 15.48721 21.77073 18.66002 -1.30836 0.599842 -3.11071

1995 17.04587 67.26233 15.42881 21.76757 18.98661 -1.22325 1.617058 -2.78096

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Year S/GDP C/GDP I/GDP G/GDP T/GDP (X-M)/GDP (S-I)/GDP (T-G)/GDP

1996 17.91797 67.27818 15.8219 21.36506 19.47311 -1.22855 2.096064 -1.89194

1997 18.84211 66.85469 16.66627 20.59791 19.87663 -1.21694 2.175844 -0.72128

1998 18.83664 67.3054 17.18087 19.83624 20.21834 -1.84 1.655768 0.3821

1999 18.3418 67.81205 17.54958 19.20351 20.2598 -2.80216 0.792217 1.056289

2000 17.53002 68.63689 17.80837 18.81023 20.67126 -3.83962 -0.27835 1.861026

2001 15.21359 69.49894 16.1566 19.24715 19.64088 -3.60677 -0.94301 0.393731

2002 14.48465 69.90218 15.47598 19.84627 17.47085 -4.01417 -0.99133 -2.37543

2003 14.75036 70.04066 15.524 20.29689 16.91871 -4.52428 -0.77364 -3.37818

2004 14.73483 69.81159 16.58774 20.16718 16.96945 -5.21327 -1.85291 -3.19773

2005 15.88967 69.7794 17.1873 20.35938 18.12017 -5.71829 -1.29763 -2.23921

2006 16.63122 69.5781 17.36859 20.36212 18.8411 -5.74152 -0.73737 -1.52102

2007 14.01741 69.73716 16.32223 20.62325 18.87881 -5.07759 -2.30483 -1.74444

2008 11.71194 70.32104 14.59173 21.70839 17.42002 -4.94394 -2.87979 -4.28837

2009 11.06665 70.83575 11.25575 24.48828 15.62292 -2.73603 -0.18911 -8.86536

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Table B:

Sectoral Composition of GDP in China

All data are from the IMF’s IFS database

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Year S/GDP C/GDP I/GDP G/GDP T/GDP (X-M)/GDP (S-I)/GDP (T-G)/GDP

1980 32.8224 50.7566 28.79227 14.73361 23.62777 -0.32006 4.030133 8.894163

1981 29.90287 52.46566 26.73894 14.64622 21.75172 0.341399 3.163931 7.105494

1982 34.2975 51.93023 26.89088 14.52415 20.10733 1.627907 7.406619 5.583184

1983 34.3986 51.9787 27.72272 14.40269 20.09266 0.81722 6.675879 5.689971

1984 34.82823 50.82375 29.1605 14.99857 20.39877 0.017657 5.667731 5.400193

1985 34.36114 51.64212 29.43801 14.31027 20.56254 -4.04442 4.923133 6.252272

1986 34.8374 50.45535 29.87772 14.46163 20.19318 -2.42851 4.95968 5.731551

1987 36.30321 49.89737 30.94059 13.67146 17.91422 0.087967 5.362617 4.242755

1988 35.7451 51.12941 30.55444 12.81078 15.31783 -0.9819 5.190661 2.507051

1989 35.72984 50.90663 25.52899 13.58419 15.39399 -1.07213 10.20085 1.809801

1990 38.58599 48.84741 24.95271 13.64289 15.18054 2.637509 13.63329 1.537643

1991 38.70827 47.52806 26.88662 14.8879 13.94758 2.735036 11.82164 -0.94032

1992 38.60005 47.16128 30.89765 15.24821 12.63695 0.999811 7.702393 -2.61126

1993 40.47214 44.43136 36.03109 14.85675 11.77375 -1.83956 4.441051 -3.083

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Year S/GDP C/GDP I/GDP G/GDP T/GDP (X-M)/GDP (S-I)/GDP (T-G)/GDP

1994 42.30279 43.49927 34.4755 14.73195 10.39102 1.26271 7.827287 -4.34093

1995 41.04985 44.87677 33.03705 13.25358 9.874258 1.579641 8.012794 -3.37932

1996 39.62465 45.78513 32.42575 13.43462 9.988728 1.967542 7.198909 -3.4459

1997 40.45149 45.21452 31.79706 13.73905 10.59424 4.347251 8.654433 -3.1448

1998 39.19921 45.33523 33.01568 14.28253 11.41317 4.194075 6.183521 -2.86936

1999 38.69374 46.74594 34.04136 15.29543 12.76134 2.649171 4.652381 -2.53409

2000 36.83074 46.21759 34.11232 15.78538 13.50104 2.409121 2.71842 -2.28434

2001 37.58131 44.88003 34.43026 16.10971 13.4604 2.120013 3.151046 -2.64931

2002 40.30222 43.68818 36.25946 15.88916 15.9337 2.571281 4.042756 0.044543

2003 43.99849 41.84446 39.38265 15.17792 16.13652 2.19867 4.615838 0.958601

2004 46.8176 39.92638 40.72962 14.51069 9.848259 2.551383 6.087986 -4.66243

2005 50.61633 38.87057 42.19303 14.52114 10.00917 5.579777 8.423307 -4.51197

2006 37.97442 42.53926 14.21189 10.63532 7.858478 -3.57657

2007 36.37805 40.97689 13.67667 9.086691

2008 36.05015 41.97592 13.54322 8.02704