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UNIVERSITY OF VERONA
DEPARTMENT OF ECONOMICS
Master’s Degree in Economics
Global imbalances and the international crisis: an
assessment of mutual relationships
Supervisor
Prof. Riccardo Fiorentini
Student
Davide Ranghetti
Academic Year 2012/2013
ii
Table of Contents
Introduction ................................................................................................................................ 1
Chapter 1. Evidences on global imbalances ............................................................................... 5
1.1 Emergence and widening of global imbalances: an overview .................................... 5
1.2 Geographical distribution of global imbalances ........................................................ 7
1.2.1 From deficit to surplus: the East Asian countries and China.......................... 7
1.2.2 Other major saving countries: Japan and the oil exporters ......................... 11
1.2.3 The European Union’s contribution to global imbalances ........................... 14
1.3 The case of the United States ................................................................................. 15
1.3.1 Persistent deficit in the current account balance........................................ 15
1.3.2 Savings ...................................................................................................... 16
1.3.3 Investment ................................................................................................ 16
1.3.4 Major drivers of the current account balance ............................................ 18
Chapter 2. Interpretations of global imbalances ...................................................................... 21
2.1 Are global imbalances good or bad? ....................................................................... 21
2.2 The Bretton Woods II Hypothesis ........................................................................... 23
2.2.1 The international monetary system in the Bretton Woods II model ............ 23
2.2.2 Twofold purpose of foreign-currency reserves accumulation ..................... 25
2.2.3 Critiques to the Bretton Woods II hypothesis ............................................. 27
2.3 The Global Saving Glut hypothesis .......................................................................... 31
2.3.1 External saving patterns at the base of the United States’ deficits .............. 31
2.3.2 Dangerous drawbacks of capital flows into the United States ..................... 34
2.3.3 Passive adaptation of the United States to the external trends .................. 35
2.3.4 Critiques to the Global Saving Glut hypothesis ........................................... 36
2.4 The role of the dollar in the international monetary system ................................... 39
2.5 Interpretations of global imbalances: a critical evaluation ...................................... 41
2.5.1 The role of the United States’ monetary policy .......................................... 41
2.5.2 The lost-lost side of the Bretton Woods II framework ................................ 45
Chapter 3. Gross financial flows and positions ......................................................................... 49
3.1 Relevance of gross financial flows and positions ..................................................... 49
3.2 Valuation effects .................................................................................................... 52
3.2.1 Net international investment position and current account balance .......... 52
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3.2.2 Components of valuation effects ................................................................ 53
3.3 The United States’ exorbitant privilege ................................................................... 57
Chapter 4. Adjustment in global imbalances ............................................................................ 63
4.1 Adjustment in current account imbalances ............................................................. 63
4.2 Evidences on adjustment after the international crisis ............................................ 66
4.2.1 Shrinkage of international current account exposures ................................ 66
4.2.2 Global imbalances and financial risk: evidences from the crisis ................... 69
4.3 The US exorbitant duty ........................................................................................... 72
4.3.1 Adverse valuation effects in time of crisis ................................................... 72
4.3.2 The United States as a global insurer .......................................................... 76
4.3.3 Exorbitant privilege and exorbitant duty compared .................................... 77
Chapter 5. China’s contribution to global imbalances .............................................................. 79
5.1 Drivers of the Chinese savings’ dynamics ................................................................ 79
5.1.1 Overview of China’s current account imbalances........................................ 79
5.1.2 The contribution of the exchange rate dynamics ........................................ 80
5.1.3 Demographic transition and reforms in agriculture and industry ................ 83
5.1.4 Major institutional reforms ........................................................................ 88
5.2 Sectorial breakdown of Chinese savings.................................................................. 90
5.2.1 Overview.................................................................................................... 90
5.2.2 The corporate sector .................................................................................. 91
5.2.3 The household sector ................................................................................. 93
5.2.4 The government sector .............................................................................. 94
5.3 Adjustment in gross financial flows and net imbalances.......................................... 95
5.3.1 Future prospects of shrinkage of Chinese domestic savings ........................ 95
5.3.2 Dynamics of gross financial flows and net balances .................................... 96
5.3.3 China’s gross external asset and liability positions ...................................... 99
5.4 Prospects of future evolution of Chinese economy and society............................. 102
5.4.1 The Chinese generations of leadership ..................................................... 102
5.4.2 Towards a new growth model: goals and challenges ................................ 104
Conclusions ............................................................................................................................. 109
Bibliography ............................................................................................................................. 118
1
Introduction
Purpose of the research
“As this report goes to print, there are more than 26 million Americans who are out of work,
cannot find full-time work, or have given up looking for work. About four million families have lost
their homes to foreclosure and another four and a half million have slipped into the foreclosure
process or are seriously behind on their mortgage payments. Nearly $11 trillion in household
wealth has vanished, with retirement accounts and life savings swept away. […] Many people who
abided by all the rules now find themselves out of work and uncertain about their future prospects.
The collateral damage of this crisis has been real people and real communities. The impacts of this
crisis are likely to be felt for a generation.” 1
With these words, in 2011 the United States’ Financial Crisis Inquiry Commission headed
by Phillip N. Angelides introduced its Final Report, with the aim to throw light on the causes of the
international financial and economic crisis which, started in 2007 as the burst of a huge speculative
housing and stock market bubble, eventually led to dramatic consequences not only in the United
States but all over the world. As underlined in the FCIC’s report, any research that seeks to delve
into the international crisis and its underlying causes cannot but go beyond the boundaries of the
mere academic treatise, but involves the consideration of issues of political and social nature. In
particular, it elicits a due reflection on the nature of an economic and social system which cyclically
spirals out of control and pours the aftermath of the resulting upheavals over workers, retirees,
taxpayers, and other ordinary people.
With this in mind to inspire the inquiry, this research proposes an investigation of the
issue of global imbalances, which have been identified by many commentators – both at the
academic and economic policy level – as one of the pivotal causes of the international crisis. Global
imbalances can be defined as unbalanced patterns of world savings and investment, which are
reflected either in persisting surpluses or deficits in the balance of payments of a number of major
countries. Current account surpluses generated by several countries – mainly Asian countries and
oil exporters – have been charged from many quarters with having fuelled the credit boom and
boosted risk-taking in the United States, by either putting significant downward pressure on world
interest rates or simply financing the speculative bubble.
For that reason, global imbalances have been at the forefront of academic and policy
debates in recent years. This subject is a highly controversial one, for global imbalances are – as in
the words of Oliver Blanchard and Gian Maria Milesi-Ferretti of the International Monetary Fund
1 FCIC (2011), p. xv.
2
– “probably the most complex macroeconomic issue facing economists and policy makers”.2
Nevertheless, deepening the issue of global imbalances in its multiple dimensions – nature, causes
and consequences – represents an essential task, for that it enables the achievement of a deeper
understanding of both the current structure of the international financial and monetary system
and the dynamics which eventually led to the dramatic outbreak of the global crisis, the effects of
which are still far from finished. This topic remains a highly actual one, in that global imbalances,
although narrowed in recent times from the pre-crisis peaks, have not entirely adjusted but in
contrast still represent one of the major features of the world economy. Furthermore, the
expected further adjustment will entails important macroeconomic drawbacks and challenges.
In this research we provide the reader with a description of the patterns of evolution of
global imbalances – both in their emergence and widening before the international crisis and in
their subsequent partial adjustment – and a discussion and critically evaluation of the main
theories and interpretations on global imbalances. To this task, an analysis of the available
empirical evidences from both economic data and the scientific literature is conducted. A
particular focus is posed on the experiences of the United States and China. In this regard, it can
be underlined how the US-China relationship, though not being capable of explaining the whole
picture of global imbalances, can help in reaching a deeper understanding of the latter, in that it
is highly emblematic of the creditor-debtor relationship which is implicit in unbalanced patterns
of world savings and investment.
This research is aimed to propose an answer to a series of pivotal research questions.
Some of them are wide-ranging and have a broad scope. What are the causes of global
imbalances? How the relationship between large deficits in the US and large surpluses in East Asian
and oil-exporting countries can be described? Have global imbalances had an influence in causing
the global crisis and, if so, in which way? How global imbalances were in turn affected by the
outbreak of the international crisis? Other questions could be raised with respect to drivers and
role of current account imbalances in single countries or regions. How could the US been able to
sustain such a broad period of continuous current account deficits? What are the factors
explaining the extremely high Chinese saving rate?
Structure of the thesis
This research is structured as follows. Chapter 1 provides an overview of the patterns of
emergence and widening of global imbalances in the decade prior to the international crisis. A
series of major countries – the United States, China, Japan – and significant groups of countries –
the East Asian emerging and newly industrialized countries, the oil-exporting countries, surplus
and deficit countries of Europe – are taken into consideration, in order to describe the
geographical distribution of world patterns of saving and investment and resulting unbalanced
2 Blanchard and Milesi-Ferretti (2009), p. 3.
3
external positions. This chapter provides a description of the major drivers and determinants of
global imbalances in both surplus countries and the United States.
Chapter 2 aims to discuss and comment theories and interpretations proposing different
approaches to the issue of global imbalances. In particular, the Global Saving Glut hypothesis and
the Bretton Woods II hypothesis are considered. This chapter provides an interpretation of the
mutual relationship between the United States and the surplus countries – which we say to
represent, at the same time, a win-win and a lost-lost relationship – and an assessment of the
relationship between global imbalances and the international crisis. We conclude that global
imbalances, though not being the immediate cause of the crisis, created the conditions for its
development, and played an important role in spreading worldwide and further magnifying its
aftermath. However, we stress how global imbalances could only unfold their adverse effects in
connection with a deregulated US financial sector.
Chapter 3 is focused on the relevance of gross capital international flows and external
positions, in contrast with the resulting net position through which global imbalanced are
traditionally measured and interpreted. We underline that focusing only on net measures of
external imbalances fails to properly assess the role of gross capital patterns that are at the core
of financial fragility. This analysis reveals some critical features of the international monetary
system and particularly of its core country, the United States – namely, valuation effects and the
US’ exorbitant privilege – which play an essential role in explaining how has been it possible for
the United States to sustain long-lasting series of large current account deficits without incurring
in a balance-of-payments crisis.
Chapter 4 describes and discusses the available empirical evidences from the post-crisis
adjustment period and provides further elements to assess the mutual relationship between
global imbalances and the international crisis. We document a pattern of shrinkage of current
account imbalances by the part of the countries which played a major role prior to the crisis, but
a simultaneous enlargement of the external net position by a number of new deficit countries - in
the first place India, Canada, Australia, Brazil, Turkey, and secondly South Africa, Ukraine and
Mexico. We discuss as well the evidence of a reversal of the usual US exorbitant privilege in times
of crisis – the US exorbitant duty.
Finally, Chapter 5 is focused on the Chinese contribution to global imbalances. This
chapter is aimed at first to highlight the main factors behind the extraordinary surge in Chinese
savings prior to the crisis. In this regard, we go beyond the common interpretation of surpluses as
a by-product of currency manipulation, to find structural demographic and economic
developments and key institutional reforms to have played a far major role. We then analyze
important evidences on the ongoing adjustment phase, and discuss the major aspects of the
debate around the expected changes in the Chinese growth model. This research concludes with
a summary in which the main findings from the different chapters are reiterated and elaborated
into integrated conclusions.
4
5
Chapter 1. Evidences on global imbalances
1.1 Emergence and widening of global imbalances: an overview
Figure 1 shows the dynamics of a proxy of global imbalances – the sum of the absolute values of
current account balances of all countries of the world – scaled by world GDP. The Figure clearly
depicts a sharp increase in imbalances in the decade 1996-2006, broken only by a slight decrease
in 2001 due to the consequences of the dot-com crisis. In 2006, global imbalances added up to
5.7% of world GDP, a level 2.7 times higher than that observed ten years before. Global imbalances
eventually underwent a drastic collapse in the period 2007-2009 as the global recession spread
worldwide, and stabilized in the very last years around 4% of world GDP, a level still double than
that prevailing in the mid-nineties.
This overall pattern does conceal large differences between countries and regions. To
better understand the geographical distribution of global imbalances across the world, it’s useful
to consider the dynamics of the current account balance of three major world economies – the
US, Japan, and China – and other four relevant country groups: surplus countries of Europe, deficit
countries of Europe, East Asian emerging and newly industrialized countries, and oil exporters.
Our choice of dividing the countries belonging to the European Union into two separate groups
depends on the fact that, while the EU as a whole has been running a roughly balanced current
account during the last decades, the single member countries has been running either current
account deficits or surpluses, and in some cases very substantial ones. Therefore, having
considered the European Union as a whole would have failed to highlight these differences.
Figure 1. Global imbalances, 1980-2012
Source: elaboration on IMF World Economic Outlook (October 2013) data
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Sum of worldcurrent accountbalances (ratio ofworld GDP)
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The group of surplus countries of Europe is composed by central and northern European
countries: Austria, Belgium, Denmark, Finland, Germany, Luxembourg, the Netherlands, and
Sweden. The group of deficit countries of Europe is primarily formed by Mediterranean, North-
Eastern and South-Eastern countries – Bulgaria, Czech Republic, Cyprus, Estonia, Greece, Hungary,
Italy, Latvia, Lithuania, Malta, Poland, Portugal, Romania, Slovak Republic, Slovenia, Spain – plus
France3, Ireland and the United Kingdom.4 The group of emerging and newly industrialized Asian
countries is composed by Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore,
Taiwan and Thailand. The group of oil exporters is composed by Algeria, Angola, Bahrain, Iraq,
Iran, Kazakhstan, Kuwait, Libya, Nigeria, Norway, Oman, Qatar, Russia, Saudi Arabia, Trinidad and
Tobago, United Arab Emirates and Venezuela. The group rest of the world is composed by all
remaining countries.
Figure 2. World distribution of current account balances, 1992-2012
3 France has been running a current account surplus between 1992 and 2004 but we’d rather insert it in the deficit group due to the strong deterioration of its balance from 2000 onward and the important deficits run since 2005. 4 We opted for a geographic rather than political approach in grouping the data, thus the countries having joined the Union in 1995, 2004 and 2007 belong to the respective groups even before the time of accession.
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EU surplus EU deficit US JPN East Asia
China Oil exporters ROW Discrepancy
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Source: elaboration on IMF World Economic Outlook (October 2013) data
Figure 2 shows the dynamics of current account balances over the last two decades with
respect to these major countries and country groups. What does immediately emerge is that over
the considered period, large and rising current account surpluses run by Japan, the emerging Asian
countries, China, the oil-exporting countries, and the core Europe countries, have had their
counterpart in large and rising current account deficit run primarily in the US, and secondly in the
UK, the Mediterranean and peripheral European countries. In particular, the deficit run by the US
grew so strongly to move from 0.4% of world GDP in 1996 to 1.6% in 2005 and 2006. In absolute
values, the US current account deficit increased from $125 billion in 1996 to $799 billion in 2006.
Wolf (2008) describes the period covering the 1990s and the years before the global
crisis as characterized by “five central features of the world”. First, an overall decrease of global
saving rates, driven by the decline of savings in the high-income countries. This is true until 2003,
when world savings and investment began to rise. Second, a concomitant decrease in the rate of
investment in the high-income countries. Third, an increase of savings and investment rates in
emerging economies and oil exporters. Fourth, the transition of high-income countries from being
net exporter to being net importer of capital, their saving rates having fallen below their
investment rates. This is true, however, particularly for the US, but not for others high-income
countries such as Japan or Germany. Fifth, the corresponding transition of emerging economies
and oil exporters from the posture of net capital importers to that of net capital exporters.5 It is
worth deepening this analysis and considering the dynamics of saving and investment for the
world major countries and country groups presented before, in order to highlight the major trends
that resulted in the overall evolution of global imbalances. This provides us with numerous
evidences useful to trace the story of global imbalances as they emerged and widened form the
mid-nineties through the outbreak of the financial crisis, and lays the groundwork for a later
discussion on different theories and interpretations.
1.2 Geographical distribution of global imbalances
1.2.1 From deficit to surplus: the East Asian countries and China
The story of recent global imbalances begins in 1997, in the aftermath of the Asian crisis. The role
of the crisis in determining the future evolution of global imbalances was essential. The crisis led
to a series of economic outcomes and policy responses in the involved countries, which in turn
contributed to shape the patterns of current account balance in the following years.6 It’s first
worth noting how, in the years prior to the crisis, the group of developing and newly industrialized
East Asian countries was running current account deficits and received the main finance from the
mature economies. The crisis started as a currency speculation against the Thailand’s bath, which
5 Wolf (2008), p. 65. 6 Bernanke (2005).
8
led to the break of the bath-dollar peg in July 1997.7 The valuation crisis then spread contagiously
to other Asian countries, in particular Malaysia, South Korea and Indonesia, which experienced
strong currency devaluations (see Figure 3).
Figure 3. Official exchange rate against the US dollar (indexes, 1990 = 100), 1990-2014
Source: elaboration on US Federal Reserve Economic Data
The collapse experienced by East Asian currencies had a devastating effect on real
economy particularly because of the large quantities of foreign-currency-denominated debt held
in those countries. Deep devaluations were thus associated with deep recessions. These countries
also had to bear significant fiscal costs to bail out their bankrupt financial systems. In this regard,
it is documented how emerging economies having suffered significant twin crises – currency and
financial – generally incurred in large fiscal costs, eventually borne by taxpayers.8 In order to
emerge from the consequences of the crisis, many East Asian countries were eventually forced to
turn to the IMF for financial assistance.
The crisis left to the involved countries a bitter memory. The harsh consequences of the
crisis are often considered to be the primary cause for the external surpluses run by the developing
and newly industrialized Asian countries as a group from 1998 afterwards.9 Wolf (2008) underlines
two main lessons taken by emerging East Asian economies from the crisis: first, the need to
improve their domestic financial systems; second, the need to make themselves less vulnerable to
sudden reversal of capital inflows. This second goal can be achieved systematically avoiding
7 Wolf (2008), p. 49. 8 Ibid., p. 54. 9 See for instance Obstfeld and Rogoff (2009), p. 137.
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Malaysian ringgit South Korean won Thai baht Indonesian rupiah
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running current account deficits. This is true because the presence of large current account
deficits, on the one hand, is often considered a negative signal capable of triggering capital
outflows. On the other hand, the correction of a large current account deficit in the occurrence of
a crisis requires a large depreciation of the real exchange rate that, in turn, causes serious
problems to the real economy in presence of a currency mismatch within the aggregate balance
sheet.10
In addition, after the crisis East Asian economies increasingly feared the floating of their
currency, because of the concern over damages caused by large changes in relative prices and
currency mismatches. A strong current account position does help also in this regard, in that it
sustains the maintenance of an undervalued exchange rate. Current account surpluses indeed are
needed to be capable of resisting any attempt to force the currency appreciation by buying more
foreign currency. Exchange rate policies to keep rates at competitive levels – compared with the
pre-crisis period – thus served a double scope: to pursue export-led strategies for maintaining high
growth rates, and to accumulate substantial stocks of international reserves as buffers against
future financial and currency crises.11
The shift from current account deficit to surplus – happened in the year immediately
subsequent to the crisis – by the part of the group of East Asian countries is highlighted in Figure
4. This policy stance has not been conceived as a temporary one, but has been maintained until
nowadays. On average, East Asian countries as a group saved each year 8.2% of GDP over the
period 1998-2012. Given that gross saving remained broadly stable at pre-crisis levels (33% of GDP
on average in the decade 1987-1997), such persistent surplus was determined by a collapse in
investment which, from the 1990-1997 average of 34%, dropped to 25% in 1998 and remained on
a similar level in the following years, and never recovered to previous levels. Significantly, patterns
of savings and investment have been only very slightly affected by the worldwide propagation of
the recent global crisis. Savings have remained stable at an average level of 32% of GDP between
2007 and 2012, while investment has dropped by three percentage points in 2007 but returned to
previous levels the year after.
As overall consequence of the Asian crisis, Wolf (2008) notes the emergence of “the
phenomenon of capital markets trying to put money into emerging economies even as the
governments of these economies, with even greater determination, recycle the funds in the form
of foreign currency reserves” and argues that “this is surely the biggest recycling operation in
history”.12 Obstfeld and Rogoff (2009) note how strong attempts were made to sterilize the effects
on the money markets of large reserve stocks accumulation, so as to dampen inflationary
pressures that might otherwise have eroded competitiveness and compromised macroeconomic
10 Wolf (2008), p. 56. 11 Ibid., p. 56. 12 Ibid., p. 84.
10
stability. However, in the 2000s up to the autumn of 2008, reserve growth still caused inflationary
pressures outside the US, driving increases in commodity, housing, and other asset prices.13
Figure 4. Saving, investment, and CA balance in East Asian countries, 1980-201
Source: elaboration on IMF World Economic Outlook (October 2013) data
Figure 5. Saving, investment, and current account balance in China, 1980-2012
Source: elaboration on IMF World Economic Outlook (October 2013) data
13 Obstfeld and Rogoff (2009), p. 138.
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The group of East Asian countries analysed before does not include China, which is
characterized by a far more peculiar picture. China was not even slightly involved in the Asian
crisis, nevertheless it is precisely in 1997 that China began to run large and increasing current
account surpluses (see Figure 5). Therefore, the Asian crisis appears to have played a major role in
influencing policy decisions and behaviours of saving and investment, as it would have proved the
danger of running persisting external deficits and the fragility of a debtor country in times of crisis.
China is now characterized by incredibly high levels of investment – the highest investment rate
of any significant economy in history14 – matched by ever higher saving rates. Investment has
increased from one third of GDP in the early 1980s to 45% of GDP in 1993. Then, after being
decreased to 35% of GDP in 2000, it has resumed its upward trend and has eventually plateaued
at an average level of 48% of GDP in 2009-2012.
Chinese savings, after having followed a similar path of investment until 2000, have then
increased at an even more pronounced rate over the following years, to reach 53% of GDP in 2008.
Over this period, the average rate of growth of savings was 4.7% per annum while that of
investment was 2.9% per annum. Consequently, the current account surplus grew from 1.7% of
GDP in 2000 to 10.1% of GDP in 2007 (an amount equal to $353 trillion). Recently, savings have
decreased to 50% of GDP in 2011 and 51% of GDP in 2012, thus narrowing the gap between savings
and investment and causing the current account surplus to reduce to 1.9% of GDP in 2011 and
2.3% of GDP in 2012. Although to a lesser extent than in the late 2000s, China is still a net creditor
towards the rest of the world, although consuming only half of its GDP. An obvious still critical
question is whether Chinese saving rates have been so high since early 2000s. The problem is
controversial and opens the way for different interpretation. For a wider discussion on the issue,
please see Chapter 5.
1.2.2 Other major saving countries: Japan and the oil exporters
It’s now worth examining how the other major countries and country groups contributed over the
years to global imbalances. Japan has been a relatively high-saving country. At the beginning of
the 1990s, the gross saving rate was roughly one third of GDP, but during the following decade it
felt steadily, to reach one quarter of GDP in 2000. It has then grown to reach 28% of GDP in 2007,
before falling to 23% of GDP in 2009 and 22% of GDP in 2012. Investment also felt as economic
growth has slowed, following a path similar to that of savings. Starting from the early 1980s, Japan
has had a persistent saving surplus that has generated a lingering current account surplus – equal,
on average on the three decades 1982-2012, to 2.6% of GDP – and net export of capital (see Figure
6). The dynamics of the Japanese balance of payments over the 1990s can be explained
considering its sectorial components separately. A massive deterioration in the public finances
offset the combined impact of a modest rise in overall private savings with a sharp decline in
14 Wolf (2008), p. 69.
12
investment, so as to prevent what would otherwise have been a combination of economic
recession and a further increase in the current account surplus.15
Figure 6. Saving, investment, and current account balance in Japan, 1980-2012
Source: elaboration on IMF World Economic Outlook (October 2013) data
Figure 7. Saving, investment, and CA balance in the oil-exporting countries, , 1980-2012
15 Wolf (2008), pp. 74-75.
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Source: elaboration on IMF World Economic Outlook (October 2013) data
Together with the East Asian countries and China, the oil-exporting countries have
played an increasingly major part of the overall picture. As shown in Figure 7, immediately after
the end of the recessionary effects of the Asian crisis, the oil exporters as a group began to run
high current account surpluses, averaging 11% of GDP in the period 1999-2012. Such net savings
were due to a broadly stable level of investment – 22.6% of the group’s GDP on average in the
decade 1997-2006, risen to 25.5% on average in the period 2007-2012 – combined with a sharp
increase in savings, which from an average level of 24.5% of the group’s GDP in the period 1992-
1998, rose to 35.5% of GDP in 2000, dropped to 29.8% in 2002 – in the aftermath of the dot-com
crisis – and then rose to a maximum of 39.8% of GDP in 2006, a level which was maintained for a
further two years, before falling in 2009 to 30.7% of GDP.
The pattern followed by savings in the oil-exporting countries in the last two decades can
be effectively explained by the dynamics of oil price in the same period (reported in Figure 8), from
which a significant surge in income has derived. Being 100 in 1982, the price of crude oil fell by
half up to the early and mid-nineties and reached a minimum of 37 in 1998 – corresponding to a
monetary price of $13 per barrel16 – due to the recessionary effects of the Asian crisis. Then rose
to 79 in 2000 and, after a slight flection in the years of the dot-com crisis, rose again to reach 272
in 2008, a level corresponding to $97 per barrel. More recently, after a collapse in 2009 (-36% on
the previous year), the oil price has risen again, up to overtake the previous maximum in 2011
($104 per barrel) and in 2012 ($105 per barrel).
Figure 8. Crude oil price (index, 1980 = 100),1980-2012
16 Simple average of three spot prices; Dated Brent, West Texas Intermediate, Dubai Fateh (Source: IMF).
0
50
100
150
200
250
300
350
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
Crude oil, simpleaverage of threespot prices (DatedBrent, West TexasIntermediate, DubaiFateh)
14
Source: elaboration on IMF World Economic Outlook (October 2013) data
1.2.3 The European Union’s contribution to global imbalances
The Eurozone’s monetary and fiscal authorities argue that it is not contributing to global
imbalances17, for Europe as a whole has been roughly in balance over the 1990s and the 2000s.
Nevertheless, the single member countries has been running either current account deficits or
surpluses, as shown in Figure 9, in which a picture of the current account balances of European
countries in 2007 is reported. As of the surplus countries, the prominent role of Germany is clear:
in this year, Germany alone generated a current account surplus equal to almost $250 trillion
(equal to 1.5% of Europe’s GDP and about two thirds of all surpluses generated by the surplus
countries’ group). Also the Netherland and Sweden generate large surpluses, equal to $53 trillion
and $43 trillion respectively. Conversely, as regard to the deficit group, Spain is the country
generating the greatest deficit – almost $145 trillion, equal to 0.8% of Europe’s GDP – followed by
the United Kingdom and Greece, with about $60 trillion and almost $44 trillion respectively.
Figure 9. Current account balances of European countries, 2007 (US$ trillions)
Source: elaboration on IMF World Economic Outlook (October 2013) data
17 Wolf (2008), p. 75.
-150 -100 -50 0 50 100 150 200 250
Germany
Netherlands
Sweden
Austria
Finland
Belgium
Luxembourg
Denmark
Malta
Slovenia
Cyprus
Estonia
Slovak Republic
Lithuania
Latvia
Czech Republic
Hungary
Bulgaria
Ireland
Romania
Portugal
France
Poland
Italy
Greece
United Kingdom
Spain
15
1.3 The case of the United States
1.3.1 Persistent deficit in the current account balance
It’s now worth look more closely to what happened in the United States. The sharp increase in the
US current account deficit is one of the most significant features of the recent developments of
the world economy. In the early 1980th, the current account moved into deficit, to remain so
throughout the whole decade of presidency of Ronald Reagan. The US current account deficit was
then eliminated by 1990, but returned to expand at a sustained rate, until reaching a maximum
value of 6.2% of GDP in the last quarter of 2005 (see Figure 10).
Figure 10. US current account deficit, 1970-2013III (quarterly data)
Source: elaboration on Bureau of Economic Analysis data
Figure 11. US savings and investment, 1970-2013 (quarterly data)
Source: elaboration on Bureau of Economic Analysis data
-7%
-6%
-5%
-4%
-3%
-2%
-1%
0%
1%
2%
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
Quarterly currentaccount balance
0%
5%
10%
15%
20%
25%
30%
19
70
19
72
19
74
19
76
19
78
19
80
19
82
19
84
19
86
19
88
19
90
19
92
19
94
19
96
19
98
20
00
20
02
20
04
20
06
20
08
20
10
20
12
Savings
Investment
16
Which were the drivers of this strongly deteriorating current account balance dynamics?
Figure 11 shows the dynamics of gross savings and investment from 1970 to the 3rd quarter of
2013. It is evident that from 1982 onwards the dynamics of savings have constantly laid under that
of investment. A disaggregation of savings and investment into their major components –
domestic business, households and institutions, government – is helpful in order to identify the
main determinants of this persistent gap.
1.3.2 Savings
Let us consider savings at first (see Figure 12). The trend of savings of the domestic business sector
has been broadly stable until 2008, mildly swinging around an average level of 13.2% of GDP (1982-
2008). In 2009 – in the aftermath of the financial crisis – this component of savings has risen,
stabilizing at an average level of 15.0% (2009-2013). Therefore, domestic business savings does
not have contributed in the period to the deterioration of the US current account balance.
Conversely, the pattern followed by savings from households and institutions does evidence how
this component has played a major role. Household savings have been constantly decreasing, from
10.5% of GDP in 1982 to 5.0% of GDP in 2007, with an average rate of decreasing equal to 3.1% a
year. As a consequence of the crisis, household savings went up to 6.6% of GDP in 2008 and 7.5%
of GDP in 2009 – a maximum level of 8.3% of GDP has been reached in the second quarter of 2009
– but then returned to fall in the following years at a rate similar to that observed in the period
1982-2007.
The pattern followed by government savings also substantially contributed to the overall
saving dynamics. Government savings have been much more volatile than the other two
components, thus representing the major determinant of the shape of total US savings' dynamics.
Government savings alternate periods of improvement to periods of deterioration. It’s worth
identifying the most significant phases which took place over the 1990s and 2000s: a sharp
increase between 1992III and 2000I (from -2.6% to 4.7% of GDP) during the Clinton administration,
a subsequent strong deterioration in the period 2000II-2003III (-2.3% of GDP at the end of the
period) in concomitance with the Afghanistan war, a relative small improvement in the period
2003IV-2006IV (1.0% of GDP at the end of the period), a huge deterioration in the period 2007I-
2009III (-8.2% of GDP at the end of the period), and an eventual recovery up to the level of -3,4%
of GDP observed in 2013III.
1.3.3 Investment
Let us now turn to investment (see Figure 13). Domestic business is the major component of US
investments, having contributed for 60% of total investment in the two decades from 1982 to
2013. Domestic business investment has been more volatile than its counterpart in savings. It is
clearly evident the strong investment boom of the nineties, followed by a contraction in
correspondence of the dot-com crisis, and then the – although narrower – investment cycle of the
mid-2000s, interrupted by the outbreak of the global crisis. From 2010, domestic business
17
investment has eventually recovered, growing from 11.0% in 2010 to 12.8% of GDP in the 3rd
quarter of 2013.
Figure 12. US savings, 1970-2013 (quarterly data)
Source: elaboration on Bureau of Economic Analysis data
Figure 13. US investment, 1970-2013 (quarterly data)
Source: elaboration on Bureau of Economic Analysis data
-10%
-5%
0%
5%
10%
15%
20%
25%
30%
19
70
19
71
19
72
19
73
19
75
19
76
19
77
19
78
19
80
19
81
19
82
19
83
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85
19
86
19
87
19
88
19
90
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91
19
92
19
93
19
95
19
96
19
97
19
98
20
00
20
01
20
02
20
03
20
05
20
06
20
07
20
08
20
10
20
11
20
12
Savings Domestic business Households and institutions Government
0%
5%
10%
15%
20%
25%
30%
19
70
19
71
19
72
19
73
19
75
19
76
19
77
19
78
19
80
19
81
19
82
19
83
19
85
19
86
19
87
19
88
19
90
19
91
19
92
19
93
19
95
19
96
19
97
19
98
20
00
20
01
20
02
20
03
20
05
20
06
20
07
20
08
20
10
20
11
20
12
Investment Domestic business Households and institutions Government
18
Households’ investment has been broadly stable until 1991. Starting from this year, it
has been gradually increasing from 3.7% of GDP to 6.6% of GDP in 2005 and up to the first quarter
of 2006, driven by the bubble of housing investment. Moreover, it can be noted how such rise in
household investment was characterized by a more sustained path in the last years of this period.
Its average rate of growth, equal to 3.3% a year between 1991 and 2002, indeed rose to 6.4% a
year between 2002 and 2006. Starting from the second quarter of 2006, the level of household
investment decreased, to plateau at a level of 3.0% in 2010-2012. Government investment has
been broadly stable in the whole considered period, averaging 4.3% of GDP in the period 1982-
2013.
1.3.4 Major drivers of the current account balance
Figures 14, 15 and 16 help visualize the contribution of each distinct sector – domestic business
households, and government – in shaping the overall dynamics of the US current account balance.
Fiorentini (2011) proposes an interpretation of the dynamics of the US current account balance
and its major drivers, dividing the US current account deficit period into three distinct phases.18
The first period, corresponding to the whole 1980s, is characterized by a deterioration of the
current account balance, which deficit enlarged to reach 3.3% of GDP in 1986 and 1987, and a
subsequent absorption of such deficit in the second half of the decade. Both investment and
savings were decreasing in the period, however the latter decreased at a more sustained rate than
the former in the first half of the decade, thus determining the widening of the current account
deficit. Major drivers in this period were both government savings – which deteriorated in the very
first years and started improving in 1982 – and households’ savings – which strongly decreased in
the first half of the decade and only partially recovered in the second half.
The second period corresponds to the nineties. During this decade the households saving
rate continued to deteriorate. However, the rebalancing of the federal budget conducted by the
Clinton administration was so strong to eventually lead the government financial balance in
surplus at the end of the decade (see Figure 16). This dynamics resulted in an improvement of the
total gross saving dynamics, at least until 1998. Between 1998 and 2000 these two effects were
instead counterbalancing each other, resulting in a slightly decreasing pattern of total savings.
During the decade, the huge investment cycle in ITC, reinforced by the – although weaker –
improvement in the level of investment of the households, resulted in an overall dynamic of total
investment which was stronger than that of gross savings, causing the current account balance to
widen further. Therefore, during the 1990s it was a rise in investment and not a fall in savings that
drove the savings gap. In this process, the driving role was taken by the private sector – business
and households – which together massively swung from financial surplus into deficit during the
bubble years of the 1990s (see Figures 14 and 15).
18 Fiorentini (2011), p. 11.
19
Figure 14. Savings, investment and CA balance of US domestic business
Figure 15. Savings, investment and CA balance of US households
Figure 16. Savings, investment and CA balance of US government
-5%
0%
5%
10%
15%
20%
19
70
19
71
19
72
19
73
19
75
19
76
19
77
19
78
19
80
19
81
19
82
19
83
19
85
19
86
19
87
19
88
19
90
19
91
19
92
19
93
19
95
19
96
19
97
19
98
20
00
20
01
20
02
20
03
20
05
20
06
20
07
20
08
20
10
20
11
20
12
Balance Savings Investment
-3%
-1%
1%
3%
5%
7%
9%
11%
13%
15%
19
70
19
71
19
72
19
73
19
75
19
76
19
77
19
78
19
80
19
81
19
82
19
83
19
85
19
86
19
87
19
88
19
90
19
91
19
92
19
93
19
95
19
96
19
97
19
98
20
00
20
01
20
02
20
03
20
05
20
06
20
07
20
08
20
10
20
11
20
12
Balance Savings Investment
-15%
-10%
-5%
0%
5%
10%
19
70
19
71
19
72
19
73
19
75
19
76
19
77
19
78
19
80
19
81
19
82
19
83
19
85
19
86
19
87
19
88
19
90
19
91
19
92
19
93
19
95
19
96
19
97
19
98
20
00
20
01
20
02
20
03
20
05
20
06
20
07
20
08
20
10
20
11
20
12
Balance Savings Investment
20
Source: elaboration on Bureau of Economic Analysis data
The third period corresponds to the years from 2000 to the outbreak of the crisis. In this
period, due to the burst of the dot-com bubble and the subsequent recession, the dynamics of
domestic business investment was far weaker than in the previous decade. Immediately after the
burst of the bubble, domestic business investment shrank rapidly and the corresponding sectorial
balance went into surplus. However, the overall US current account deficit widened further. Until
2003 the main driver of the expanding deficit was the strong deterioration of the federal budget
under the Bush administration. Between 2003 and 2006, conversely, the prevailing factors can be
identified in the resumption of domestic business investment and in a strong increase in the rate
of investment of the households, which combined with by the persisting decrease in their rate of
saving, led – for the first time – to a negative household balance.
21
Chapter 2. Interpretations of global imbalances
2.1 Are global imbalances good or bad?
Both before and after the global crisis, economists and commentators have proposed a great
number of different approaches to the issue of global imbalances. Underlying all researches there
is a reflection on the nature of global imbalances themselves, which the question “Are global
imbalances good or bad?” can easily synthetize.19 Although it might seem a very straightforward
one at first sight, such reflection opens a large number of critical research questions and
consequent roads to interpretation. Blanchard and Milesi-Ferretti (2009) effectively synthetize the
great difficulties faced in analysing and interpreting world imbalances:
“Global imbalances are probably the most complex macroeconomic issue facing
economists and policy makers. They reflect many factors, from saving to investment to portfolio
decisions, in many countries. These cross-country differences in saving patterns, investment
patterns, and portfolio choices are in part “good” – a natural reflection of differences in levels of
development, demographic patterns, and other underlying economic fundamentals. But they are
also in part “bad”, reflecting distortions, externalities, and risks, at the national and international
level. So it is not a surprise that the topic is highly controversial, and that observers disagree on
the diagnosis and thus on the policies to be adopted.” 20
The main questions which need to be addressed refer, on one hand, on the causes of the
emergence of large global imbalances in the pre-crisis period and, on the other hand, on their
consequences, and in particular on the relationship between global imbalances and the recent
global crisis. The fact that global imbalances are not in principle a bad phenomenon is highlighted
by many commentators. Given the great number of micro and macroeconomic factors that affect
the dimension and balance of the current account, and given the increased integration and
globalization of world economy, there is no reason in principle for current account balances to be
offset. Current account balances are driven by the dynamics of saving and investment patterns,
thus imbalances can emerge naturally from differences in saving behaviour, in the rate of return
on capital, or in the degree of risk or liquidity of different assets. Furthermore, also export and
import patterns – driven by differences in productivity, exchange rates and term of trades
between countries – obviously can play a major role in determining the dynamics of trade accounts
and thus current account balances. The case that global imbalances – even large ones – are not a
bad phenomenon, but only reflect the optimal allocation of capital across time and space, is thus
given. Amongst others Cooper (2007) and Dooley, Folkerts-Landau, and Garber (2003) proposed
frameworks reflecting this approach, in which developing countries’ residents and governments
19 Blanchard and Milesi-Ferretti (2009), p. 3. 20 Ibid.
22
enjoyed safety and liquidity for their savings, while advanced countries benefited from easier
borrowing terms.
From this approach one may derive the idea of global imbalances as an entirely win-win
phenomenon, in which all countries involved take advantage of those un-equilibrated patterns of
trade and finance. This perspective would exclude both bad causes and bad consequences of
global imbalances. A justified scepticism arises about whether this was the case as regard global
imbalances that emerged in the pre-crisis period. According to this interpretation, the outbreak of
the global crisis in 2007 would not be related at all with global imbalances, which found its causes
in other market failures. This thesis doesn’t seem to be convincing. Most commenters indeed
recognize some form of relationship between global imbalances and the global crisis. A major line
of interpretation states that global imbalances – regardless of their origin, which might also reflect
good/natural economic drivers as explained before – would have played a prime role in causing
the financial collapse, by creating inefficient outcomes and increasing risk. 21 In this view, global
imbalances are dangerous by themselves, in other words have bad consequences. Ben Bernanke
and Henry Paulson, respectively former Chairman of the Federal Reserve and former US Treasury
Secretary, share this though and argue that global imbalances – namely the high savings of China,
oil exporters and the other surplus countries – depressed global real interest rates, leading
investors to struggle for higher yield and underprice risk, and this in turn laid the path to the crisis.
According to other lines of interpretation, external imbalances would have played a little
role in causing the crisis, which instead resulted mainly from financial regulatory failures and policy
errors. Nevertheless, even denying the existence of a strong causal relationship between global
imbalances and the crisis, one can recognize that the former may be symptoms of underlying
distortions – thus have bad causes – and likely of the same distortions that have eventually led to
the crisis. In this perspective, global imbalances are not to be considered bad per se, but should
be carefully evaluated, as significant signs of potentially dangerous features of unbalanced growth
of the world economy. Between the others, Lorenzo Bini Smaghi in his speech at the Asia Europe
Economic Forum in 2008, considered global imbalances and the financial crisis “two sides of the
same coin” and the former as “a reflection, and even a prediction, of internal imbalances”.22 Let
us make this explicit by considering different drivers of saving behaviour. High levels of private
saving may reflect private choices of intertemporal allocation of consumption. As instance,
demographic factors such as a marked aging rate of the population may underlie rising patterns
of private saving, which find their micro-foundation in the precautionary behaviour of households
which save in anticipations of the dissaving that will occur when simultaneous movements of
workforce shrinkage and expansion of the number of retiree will appear. At the same time, such
private choices may well reflect features of a negative economic environment, such as the lack of
21 Blanchard and Milesi-Ferretti (2009), p. 4. 22 Bini Smaghi (2008).
23
social insurance which forces people to engage in high precautionary saving.23 Thus, high private
saving is not necessarily good. Similarly, low levels of private savings may clearly highlight market
distortions, such as bubble-driven asset booms.
Obstfeld and Rogoff (2009) propose an intermediate and somehow more nuanced line
of interpretation. Global imbalances are not viewed as the prime cause of leverage and housing
bubbles, but still as an important co-determinant. Moreover, it is recognized that global
imbalances played an important role in spreading worldwide the effects of the crisis. In this view,
global imbalances “both reflected and magnified the ultimate causal factors behind the recent
financial crisis”.24 In my opinion this is a fully sharable approach, in that – as Blanchard and Milesi-
Ferretti (2009) argue – every “one-size-fits-all” explanation is unavoidably partial and misses the
essential complexity of the economic developments of 1990s and 2000s.25 It is now worth
considering some of the most important theories about global imbalances: the Bretton Woods II
hypothesis and the Global Saving Glut hypothesis.
2.2 The Bretton Woods II Hypothesis
2.2.1 The international monetary system in the Bretton Woods II model
The so-called “Bretton Woods II Hypothesis” has been proposed in 2003 by Michael P. Dooley of
the University of California, Santa Cruz, and David Folkerts-Landau and Peter M. Garber of
Deutsche Bank, and represents one of the sharpest contributes amidst those referring to the
perspective of the Sino-American co-dependency. The fundamental idea of this framework is that
the original Bretton Woods system, far to be finished at the beginning of the 1970s, has instead
remained the same throughout the years, just manifesting itself in different forms. The
international monetary system – as proposed by the “revived Bretton Woods” proponents – is
composed by three distinct economic and currency zones in the world.26
The US alone represents the centre country of the system. The peripheral trade account
region, originally composed by Europe and Japan, is now composed by Asian countries. This
second region poses its greatest interest in enhancing export opportunities to the centre country,
and follows this strategy through exchange rate management, namely official interventions to
limit the currency’s appreciation. These peripheral countries choose “a development strategy of
undervalued currency, controls on capital flows and trade, reserve accumulation, and the use of
the centre region as a financial intermediary that lent credibility to their own financial systems”.
Also, peripheral countries buy US securities to finance the discrepancy between domestic savings
and investment, without regard to the risk/return characteristics of such securities. By its part, the
23 Both fast ageing of the population and lack of a developed social security network have been observed in China. For a deeper discussion of these topics, please see Chapter 5. 24 Obstfeld and Rogoff (2009), p. 133. 25 Blanchard and Milesi-Ferretti (2009), p. 11. 26 Dooley, Folkerts-Landau, and Garber (2003).
24
US lends “long-term to the periphery, generally through FDI”. A third region, the capital account
region, is now composed by Europe, Canada and Latin America. Members of this region care about
the risk/return of their international investment position and US exposure and are floaters in their
currency policies. Thus, countries belonging to the capital account region neither have the
periphery’s scope for catch-up nor the centre country’s ability to live beyond its means.
The authors view the thirty years between 1971 and the end of the 1990s as a temporary
hibernation – or suspension – of the Bretton Woods system. When the original periphery
graduated to the centre shifting its development strategy toward free capital markets, financial
controls were lifted and the fixed rate system collapsed into a floating regime. This period is
viewed only as a transitional stage during which there was no important and sizeable periphery
that based its development strategy on export-led growth. However, at the beginning of the
1990s, a new periphery – mainly composed by Asian countries – chose the same strategy as
immediate post-war Europe and Japan. The success of this group has brought at the beginning of
the 2000s the structure of the international monetary system to its essential Bretton Woods era
form. Therefore, “the system has not changed, but the objectives for important blocs of countries
within the system have changed over time”. The dynamics of the whole system – in terms of
reserve accumulation, net capital flows and exchange rate movements – is determined by the
development of the trade account region, which is thus recognized to be its driving force. In the
future – but, as claimed by the authors, “that point will not be reached for perhaps ten more years”
– the trade account countries will reach a developmental stage that will bring them to join the
floating exchange rate group and to be replaced by other countries, such as India. Thus, it’s
concluded, “the Bretton Woods system does not evolve, it just occasionally reloads a periphery”.27
Summarizing, recent global imbalances are thus viewed as win-win situation resulting
from an implicit bargain between the emerging and newly industrialized East Asian countries and
the US, with the former pegging their currency to the US dollar in order to support their export-
led growth strategy by undervalued and heavily managed exchange rates, capital controls and
official capital outflows in the form of accumulation of reserve asset claims on the US itself. By the
part of the East Asian countries, such policy strategy can be seen as a form of exchange rate
protectionism aimed to promote production of tradable goods. Also the centre country does
benefit from this bargain. Indeed, as in Dooley, Folkerts-Landau and Garber (2003), the US “has
been happy to invest now, consume now, and let investors worry about its deteriorating
international investment position”. Moreover, according to the Bretton Woods II proponents, the
structure sustaining such bargain is overall stable in the long run:
“In spite of the growing US deficits, this system has been stable and sustainable. […] But
as US debts cumulate, US willingness to repay both Asia and Europe comes more naturally onto
the radar screen, so the system that was previously stable could run into trouble. […] But our
27 Dooley, Folkerts-Landau, and Garber (2003).
25
analysis of behaviour of trade account countries suggests that Asia […] will accept an even larger
inflow of US securities. If so, yields in the US will not rise. […] Trade account countries will resist
appreciation. They will cumulate even more low-yielding US securities.” 28
2.2.2 Twofold purpose of foreign-currency reserves accumulation
As in Wolf (2008), a major policy consequence of this framework is the need for Asian countries
to generate the large amount of savings that are the counterpart of the current account surpluses,
because “if that is not achieved, there will be excess spending, inflation, an erosion of
competitiveness, and the eventual failure of the policy”. Wolf deepens further this argument. If a
country manages to fix its real exchange rate below the market clearing level, current account
surpluses will emerge and – provided that the country is sufficiently open to trade and thus the
capital account is sufficiently porous – speculative capital will flow into the country to bet against
a future exchange rate appreciation. To keep the exchange rate low, the authorities must buy the
incoming foreign money and transfer it into the foreign-currency reserves. Also, they must “ensure
that the excess of income over spending implicit in the current account surplus is sustained” by
means of “a mixture of fiscal policy measures (higher taxes and lower spending) and monetary
policy measures”, these latter pursued in order to sterilize “the consequences of the buildup of
central bank money […] needed to buy the surfeit of foreign currency coming onto the market”.
Otherwise, the economy will overheat and the real exchange rate will appreciate through higher
inflation rather than through a rise in the nominal exchange rate.29
Accumulation of large current account surpluses and foreign-currency reserves thus can
be seen as a direct consequence of the exchange rate protectionist strategy chosen by East Asian
developing and newly industrialized countries. Figure 17 shows the dynamics of reserve
accumulation from 2001 onward for the US, China, Japan, and the emerging and newly
industrialized East Asian countries. The picture clearly depicts the role played in this regard by
China, which in a decade – between 2001 and 2012 – has increased the consistency of its reserves
from $212 billion to almost $3,500 billion, an amount more than 15 times higher. By means of
reserve accumulation, not only can a country sustain its protectionism policies and enhance its
industrial growth by promoting export and unbalancing its economy in favour of competitive and
towing manufacturing sectors. Moreover, it can also insure itself against financial crisis and sudden
capital flights – as happened at the time of the Asian crisis in 1997. Indeed, if a country manages
to accumulate an amount of reserves large enough to service foreign debt for an extended period
of time, then it is able to guarantee its solvency in the occurrence of a financial crisis.30
Figure 17. Foreign-currency reserves (billions of USD), 2001-June 2013
28 Dooley, Folkerts-Landau, and Garber (2003). 29 Wolf (2008), p. 82. 30 Fiorentini (2011), p. 16.
26
Source: elaboration on IMF data
Accumulation of foreign reserves can be considered a way to offer collateral to foreign
investors so as to attract inflow of foreign capital in the form of FDI, which contributes to capital
stock formation. Thus to the first relationship – foreign-currency reserves as a consequence of
exchange rate protectionism – which is stressed in the first formalization of the Bretton Woods II
hypothesis, this second major reasoning – foreign-currency reserves as collateral for FDI – is added
in completion of the model. This topic is the main focus of later works of its proponents, such as
Dooley, Folkerts-Landau and Garber (2004) and Dooley, Folkerts-Landau and Garber (2007). In this
second contribute, this concept is summarized as follows:
“Rapid industrialization requires a large inflow of direct and portfolio equity investment;
and, in turn, a large current account surplus is required for the periphery to provide the collateral.
Contrary to almost universal opinion, successful economic development is powered by net savings
flows from poor to rich countries. The current account imbalances of the rich countries do not pull
the periphery along by providing global net aggregate demand; they push the periphery by
securing efficient capital formation.” 31
In this perspective, the need of developing Asian countries to rely largely on FDI is
justified by the contradiction between high saving rates and still undeveloped and inefficient
financial markets, thus unable to transform national savings into corresponding flows of domestic
investment. This is instead the role assumed by the US financial sector, which does transform the
incoming Asian savings into an outflow of FDI returning to the origination countries and further
enhancing their economic development. In Fiorentini (2011) the nature of the implicit bargain on
31 Dooley, Folkerts-Landau and Garber (2007).
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which the Bretton Woods II system does base is clarified: the US “offers FDI, international liquidity
and collateral in the form of growing dollar reserves held by Asian countries” while the latter
“finance the US current account deficit by buying American assets, providing a supply of low cost
credit to US household and firms”.32
2.2.3 Critiques to the Bretton Woods II hypothesis
The idea that East Asian countries accumulate current account surpluses as collateral for FDI inflow
and capital stock formation is the centre of the harsh criticism of the Bretton Woods II model
which can be found in Wolf (2008). It’s worth briefly deepening these argument. First, a primary
role of FDI in contributing to the capital stock formation of East Asian countries – in particular, in
creating an internationally competitive industrial sector – is denied. On the contrary Wolf argues
as “these countries were, and to a substantial extent are, resistant to affording any such role to
FDI”. The emblematic case of the US-China relationship is presented. FDI from the US are reported
to have financed under 5% of China’s fixed investment in the first half of the 2000s, an amount
that is considered far too small to have determined the efficiency of the overall Chinese capital
stock. Moreover, it’s argued that “China does not conform to the hypothesis that currency
undervaluation will bias domestic investment in favour of tradable goods” but – on the contrary –
US investment in China seems to be heavily biased toward production for the domestic market
rather than production of traded goods to be sold abroad and in the US itself. East Asian countries
in general, it’s added, seem not to have directed inward FDI to the industrial sector or to
production for world markets, but rather to production for the home market behind protectionist
barriers.33
Second, the supposed role played by foreign-exchange currency reserves as collateral
against seizure of part or all of the inward stock of FDI inflows is also denied. It is underlined, at
first, how the large outright emerging market defaults which occurred over the 1990s were on
bonds or bank debt, rather than on equity investment, and that this latter investment seems not
to require collateral in the form of official reserves in order to be conducted. Then, it is pointed
out that a relationship between accumulation of reserves and FDI inflow seems not to be
confirmed by the available data. With respect to the China-US relationship again, it is underlined
how the accumulation of massive reserves by China is recent and coincides with a decline and not
an increase in its dependence on inward FDI, “which has fallen from financing 12% of Chinese fixed
investment in the mid-1990s to financing only 4% in the mid-2000s”.34 In this regard, Wolf (2008)
adds that “if the Chinese authorities were accumulating foreign currency reserves in order to
convince inward investors that they would not seize their assets, one might expect them to say
so” or alternatively “some of the investors to have pointed this fact out to their shareholders”.
32 Fiorentini (2011), p. 16. 33 Wolf (2008), pp. 142-143. 34 Ibid., p. 144.
28
However, he admits to be “unaware of any statements to either effect”, thereby confirming his
belief in the implausibility of the proposed interpretation.35
The accumulation of reserves is thus not seen in Wolf (2008) as a policy choice but
essentially as by-product of the pegged exchange rate. Following this perspective, the Chinese
government did not plan the swing in flows of capital nor the explosion in the current account
surplus, both of which drove the reserve accumulations since the early 2000s and in particular
after 2004.36 Wolf thus concludes that the Bretton Woods II theory is unnecessary. This argument
is made explicit again with respect to the relationship between the US and China:
“All one need suppose is that the Chinese authorities have two predominant objectives:
monetary stability and satisfactory levels of economic growth. For a country with a primitive
financial system and an economy increasingly oriented to the outside world, the exchange rate
peg is a simple way of providing the former. It has also proved consistent with the latter. In recent
years, the peg has led to the rapid accumulation of foreign-currency reserves. Initially this was
almost certainly welcome as a form of insurance. Subsequently it has been something of a
problem, not least because of the challenge of sterilization (not insurmountable, but tricky) and
the friction with the US. But that difficulty has not yet been enough to warrant changing the policy
radically, since there is a significant risk that doing so would imperil China’s two primary
objectives.” 37
Some considerations can be made with reference to the relationship between official
reserves, FDI and capital formation. Figure 18 reports the dynamics of gross capital formation and
FDI in China as a share of GDP, and the percentage contribution of the latter to the former. China’s
dependence on FDI actually decreased during the decade 1993-2003 as reported by Wolf (2008),
but it somehow revived later on and in particular in the years 2005-2008, when it represented
again more than 10% of gross stock formation. Moreover, this trend appears to have been
substantiated more by the strong increase in overall capital formation – which has grown from a
quarter of GDP in the early 2000s to 40% in the mid-2000s and 45% in the early 2010s – rather
than a decrease of FDI inflow itself, which has swung around an average of 4% of GDP in the two
decades 1992-2012. The role played by FDI – with respect to Chinese external position – has
instead remained strong, as proven by Figure 19, in which the composition of China’s gross
external liabilities is reported. Total external liabilities averaged 35% of GDP between 2004 and
2008, and then have grown to a level of about 40% between 2009 and 2012. The share of FDI on
total liabilities increased from 57% in 2004-2007 to 63% in 2008 and 68% in 2009. It has eventually
decreased to 63% in 2011 and 2012.
Figure 18. China’s inward FDI (ratio to GDP and % of gross capital formation), 1982-2012
35 Wolf (2008), p. 146. 36 In this regard, see Figure 54 in Chapter 5. 37 Wolf (2008), p. 146.
29
Source: elaboration on World Bank data
Figure 19. Composition of Chinese gross external liabilities, 2004-2013III
Source: elaboration on China State Administration of Foreign Exchange data
Therefore, if it’s true than China does rely to a lesser extent to FDI for its overall capital
formation, it’s true as well that FDI is still the major component of China’s external liabilities. China
has kept attracting FDI over all the 1990s and 2000s and in this regard its role within the
international arena has progressively increased. China has been among the world’s top 20
destinations for FDI since 1982, among the top 10 since 1992, and have been on the “podium” –
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FDI in China
30
first, second or third world’s top destination – in the period 1993-1998 and since 2002 (except for
2005, 4th place, and 2007, 7th place). In particular, China has covered the second position after the
US uninterruptedly since 2009. Moreover, the contribution of FDI to capital stock formation should
be evaluated not only with respect to its quantitative proportion, but also from a qualitative point
of view, with respect to its role in spurring the modernization of Chinese indigenous capital stock
as regard technology, organizational issues, managerial procedures, etc. That being said, the
argument presented by Wolf should be somewhat damped. On the grounds that foreign-currency
reserves don’t appear to have been built with the primary goal of serving as collateral for FDI, one
should not entirely exclude this relationship. On the contrary, one could interpret reserve
accumulation as a by-product of the pursued export-led growth strategy and at the same time not
underestimate the function of collateral for FDI – at least consider it as a sort of positive
externality.
Other researchers have dispensed critical comments to the Bretton Woods II hypothesis.
Amongst others, it’s worth considering a contribution by Barry Eichengreen of the National Bureau
of Economic Research. Eichengreen (2004) did recognize that the Bretton Woods II proposal helps
to understand how the pattern of global imbalances was shaping – at that time – the overall
structure the international monetary and financial system, and in particular the role of the
peripheral countries and their “willingness to trade wage restraint and accept lower levels of
consumption in return for faster investment and export growth rates that promised to deliver
significantly higher living standards down the road”.38 However, it was underlined how the model
entailed important elements of misunderstanding. Firstly, it was argued that this approach was
likely to hide or underestimate the large differences which existed between the international
monetary and financial structure of the original Bretton Woods agreement and that of its
“revived” version. In particular, Eichengreen (2004) underlined that, while in the 1960s there was
no attractive alternative to the dollar, in the 2000s the euro could likely represent an attractive
“next best alternative”.39
Secondly, it was noted that “the readiness of foreign central banks to hold onto dollars
[…] depends on their perception of the reserve-currency country’s commitment to maintaining
the value of their claims”. The prospect for the dollar to maintain its value against foreign
currencies was seen by Eichengreen (2004) to be far more dubious in the 2000s than in the 1960s.
While back to those years, US capital outflows reflected high saving rates – which have more
favorable implications for debt sustainability – in the 2000s the US external deficit reflected a low
saving rate, which instead raised doubts on the fiscal capacity to sustain the debt at unchanged
prices. Moreover, Eichengreen (2004) argued that the Asian policymakers would soon have
understood that the international monetary and financial system was changing “in ways that
diminish the attractions of systematic undervaluation designed to promote export led growth”,
38 Eichengreen (2004), p. 3. 39 Ibid., p. 5.
31
this making them less likely to “blindly repeat the policies of the past”. In that regard, the risks
entailed in indefinitely continuing such a policy choice were highlighted:
“[…] the liberalization of domestic financial markets means that keeping the exchange
rate low and domestic savings high no longer guarantees that additional investment will be
centered in the traded goods sector. In the present deregulated financial environment there is a
tendency for loose credit conditions to pump up investment in nontradables, notably property,
fueling building booms and heightening financial fragility. Asian governments are increasingly
aware that the current strategy entails these risks, creating an incentive to modify it sooner rather
than later.” 40
2.3 The Global Saving Glut hypothesis
2.3.1 External saving patterns at the base of the United States’ deficits
While the Bretton Woods II hypothesis proposes a win-win framework and denies any causal
relationship between the rise in global imbalances and the outbreak of the crisis, the Global Saving
Glut hypothesis implies a strong causal relationship between the surge in Asia savings, US
indebtedness and the economic development that eventually led to the crisis. This approach is
based on the observation that any account for the pattern of global imbalances needs also to be
consistent with the evidence on real interest rates. Figure 20 shows the dynamics of a proxy for
the US long-term real interest rate, the 10-years treasury inflation-protected securities (TIPS)
interest rate. Such rate rose mildly until 2000, and a similar pattern was followed also by other
industrial countries’ government long-term inflation-indexed rates. Early 2000 marked the peak
of the US equity market and the prelude to the dot-com collapse. In this year, the US long-term
real rate started to decrease at a sustained pace to reach low levels from a historical perspective.
In his famous speech at the Sandridge Lecture of the Virginia Association of Economists
in 2005, Ben Bernanke argued that both the low level of long-term interest rate in the world and
the expansion of US external deficits starting in the latter 1990s could be explained by a sustained
increase in global savings determined by an outward shift of emerging market saving schedules –
what he calls a “global saving glut”. According to this theory, the appearance of a “global saving
glut” let to worldwide asset-price adjustments that in turn induced a number of mature
economies, first and foremost the US, to borrow more heavily from foreigners.
Figure 20. US long-term real interest rate, 1997-January 2014
40 Eichengreen (2004), p. 6.
32
Source: elaboration on US Federal Reserve Economic Data
The global saving glut theory postulates that the principal reason explaining the
consistency of the low level of real interest rates and the large and increasing size of the US current
account is that a large number of countries were unable – or unwilling – to absorb their savings,
even at low real rates of interest. Therefore, in this perspective the sphere in which global
imbalances originated is a global one rather than a US-specific one. This view has been effectively
summarized by Lawrence Summers in a lecture at the Reserve Bank of India in 2006:
“There is one striking fact about the global economy that belies a dominantly American
explanation for the pattern of global capital flows: real interest rates globally are low, not high.
Whether one looks at index bond yields, measures of nominal interest rates relative to ongoing
inflation, and yields on most assets, especially real estate or credit spreads, capital market pricing
points to the supply of global capital tending to outstrip demand rather than vice versa. Real
interest rates globally are low not high from an historical perspective. If the dominant impulse
explaining global events was declining US savings, one would expect abnormally high real interest
rates, as with the twin deficits in the 1980s, not abnormally low interest rates. America’s
consumption growth in substantial excess of income growth has been matched by substantial
export led growth in the rest of the world.” 41
Bernanke (2005) did admit that the US current account deficit was the product of a
decline in the US national saving rate to a level far from adequate to fund domestic investment.
41 Summers (2006).
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However, he stressed that “linking current-account developments to the decline in saving begs the
question of why US saving has declined”. The explanation he proposed for this phenomenon was
based on the observation that, in the period 1996-2003, the current account balance decline
experienced by the industrial countries as a whole – for and foremost by the US – was offset by a
corresponding shift in the current account position of developing countries, which swung from a
collective deficit to a collective surplus. Bernanke (2005) argued that “a key reason for the change
in the current account positions of developing countries [was] the series of financial crises those
countries experienced”. He explained:
“In response to these crises, emerging-market nations either chose or were forced into
new strategies for managing international capital flows. In general, these strategies involved
shifting from being net importers of financial capital to being net exporters, in some cases very
large net exporters. […] Increases in foreign-exchange reserves necessarily involve a shift toward
surplus in the country's current account, increases in gross capital inflows, reductions in gross
private capital outflows, or some combination of these elements. […] These "war chests" of foreign
reserves have been used as a buffer against potential capital outflows. Additionally, reserves were
accumulated in the context of foreign exchange interventions intended to promote export-led
growth by preventing exchange-rate appreciation.”
Bernanke (2005) divided the period 1996-2003 in two halves. In the first one (1996-
2000), “equity prices played a key equilibrating role in international financial markets”. During the
bubble-based investment cycle, the US economy was “exceptionally attractive to international
investors” and consequently “capital flowed rapidly into the United States, helping to fuel large
appreciations in stock prices and in the value of the dollar”. A deepening of the developments of
this earlier period was proposed in the following terms:
“From the trade perspective, higher stock-market wealth increased the willingness of US
consumers to spend on goods and services, including large quantities of imports, while the strong
dollar made US imports cheap (in terms of dollars) and exports expensive (in terms of foreign
currencies), creating a rising trade imbalance. From the saving-investment perspective, the US
current account deficit rose as capital investment increased (spurred by perceived profit
opportunities) at the same time that the rapid increase in household wealth and expectations of
future income gains reduced US residents' perceived need to save. Thus the rapid increase in the
US current account deficit between 1996 and 2000 was fuelled to a significant extent both by
increased global saving and the greater interest on the part of foreigners in investing in the United
States.”
As underlined by Obstfeld and Rogoff (2009), Bernanke considered the set of domestic
causal factors of US indebtedness – amongst others, expectations of rapid future productivity
growth in the US – of secondary importance compared with the effects of increased emerging
34
market savings and, in particular, only a very minor role was assigned to monetary policy.42 The
year 2000 represents a turning point in the analysis. The bust of the dot-com bubble and the
consequent stock-market decline led to a situation in which new capital investment and demand
for financing dropped at a worldwide scale, while desired global saving in the developing countries
remained strong. As a consequence, real rates of interest fell, in order to equilibrate the market
for global saving. In this regard, Bernanke (2005) underlined that “the weakening of new capital
investment after the drop in equity prices did not much change the net effect of the global saving
glut on the US current account”. However, “the transmission mechanism changed […] as low real
interest rates rather than high stock prices became a principal cause of lower US saving”. In this
second period starting in 2000, the key asset-price effects of the global saving glut did manifest
particularly in the market for residential investment, as low mortgage rates supported record
levels of home construction and strong gains in housing prices.
2.3.2 Dangerous drawbacks of capital flows into the United States
The global saving glut hypothesis implies the existence of dangerous drawbacks – or bad
consequences of global imbalances – in particular with respect to the US internal economic
developments. Bernanke (2005) recognized that the economic developments he took into account
had some benefits, particularly for developing countries which were able to reduce their foreign
debts, stabilize their currencies, and reduce the risk of financial crisis. However, he also highlighted
the areas in which unbalanced patterns of international capital flows could result in unproductive
outcomes. A first issue of concern was detected in the uses of international capital inflows to the
United States. In the years after the dot-com crisis, investment by businesses in equipment and
structures was relatively low, and much of the capital inflow showed up in higher rates of home
construction and in higher home prices, which in turn encouraged households to increase their
consumption.
In this regard, Bernanke (2005) stressed how “the greater the extent to which capital
inflows act to augment residential construction and especially current consumption spending, the
greater the future economic burden of repaying the foreign debt [was] likely to be”. A second issue
of concern was raised with reference to the effects of financial inflows on the sectorial
composition of the US economy. In this regard, it was pointed out how in the US, the growth in
export-oriented sectors such as manufacturing was restrained while sectors producing non-traded
goods and services, such as home construction, grew consistently. Bernanke (2005) underlined
that – in order to repay foreign creditors – “the United States [would have needed] large and
healthy export industries”, and that “the relative shrinkage in those industries in the presence of
current account deficits” would have imposed “real costs of adjustment on firms and workers in
those industries”. A third issue of concern was related to the risk of a disorderly adjustment in
42 Obstfeld and Rogoff (2009), p. 141.
35
financial markets linked to the substantial flow of foreign financing that large current account
deficits did require.
2.3.3 Passive adaptation of the United States to the external trends
From the global saving glut perspective does derive the idea of the US passively adapting to
external trends in world saving. Wolf (2008) deepens further this argumentation, sustaining that
we live in a world where “the tail wags the dog of US macroeconomic policy”.43 In a world of fixed
exchange rates, such as that of the original Bretton Woods period, the US could not have a
currency policy. On the contrary, its exchange rate was determined by the decision of all countries
which targeted the US dollar. The collapse of Bretton Woods in 1971 was indeed made possible
not only by the breakage of the link between gold and the dollar, but also by import surcharges
imposed by the US to trade partners, in order to force them to appreciate their currencies against
the dollar. Indeed the only way for the US to devalue to dollar was forcing the other countries to
change their exchange rate policies.
Similarly, Wolf (2008) argues that in the 2000s the US could have an exchange rate policy
only with respect to the currencies that float, but it could not force its currency down by
intervention against the currencies of countries that were prepared to invest in reserves without
a limit. As a consequence, US policy makers were constrained. The rest of the world’s choice to
support the dollar, sterilize the monetary consequences, and hold US liabilities generated a certain
real exchange rate for the US. At this given real exchange rate, the level of demand that generated
internal balance also generated a very large US excess demand for tradable goods. In turn, the
Federal Reserve had to “pursue a monetary policy sufficiently expansionary to generate this level
of domestic demand, in order to secure the desired internal balance – that is, to avoid ever-falling
inflation and ultimately deflation”.44 Thus, if the US policy makers targeted the achievement of
internal balance, the current account deficit needed to absorb the desired excess savings of the
rest of the world would have emerged naturally. The whole process is effectively summarized as
following:
“One can explain what is going on, simply put, as follows. The rest of the world’s capital
outflow supports the dollar. At the resulting elevated real exchange rate for the United States, the
output of the sectors in the US economy that produce tradable goods and services shrinks, other
things being equal. The Federal Reserve cuts interest rates to expand the economy, thereby
preventing excessive unemployment. As it does so, a large excess demand for tradable goods and
services emerges in the United States. This, finally, appears in the trade and current account
deficits.” 45
43 Wolf (2008), p. 98. 44 Ibid., p. 99. 45 Ibid., p. 100.
36
2.3.4 Critiques to the Global Saving Glut hypothesis
As pointed out by many commentators, the consistency of the Bernanke’s explanation of the US
current account deficit should be supported by the evidence of a strict time sequence between
the emergence of current account surpluses outside the US and the decrease in the level of global
long-term real interest rates and US savings. However, it is often argued that this seems not to be
the case. Obstfeld and Rogoff (2009) stress how the data do not support the claim that the
proximate cause of the fall in global interest rate started around 2000 was a contemporaneous
increase in desired global savings. Indeed, data provided by the IMF support the evidence that
global savings fell between 2000 and 2002, and begin to rise only in that year (see Figure 21).
Obstfeld and Rogoff (2009) thus interpret the fall in real interest rates as more closely
related – in the early 2000s – to the global decline of the high-tech sector. To be more precise, it
is argued that a more plausible explanation of the downturn trend of global real interest rates can
be found in market perceptions about the end of the tech-driven productivity boom of the 1990s
rather than in the rise in global savings that occurred only later in the decade.46 This situation
changed in 2003 and 2004, when the world saving rate begin to increase steadily, driven by large
savings by commodity exporters and East Asian countries, which outweighed decreased savings
elsewhere in the world.
Figure 21. World saving and investment rates, 1980-2012
Source: elaboration on IMF World Economic Outlook (October 2013) data
46 Obstfeld and Rogoff (2009), p. 142.
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Obstfeld and Rogoff (2009) confirm the Bernanke’s view in arguing that “this increase in
world saving may help explain why long-term global real interest rates remained relatively low, as
did nominal long-term rates, despite a shift toward monetary tightening in industrial countries
starting in 2004”.47 Indeed, it is recognized how an interpretation of saving/investment dynamics
as being driven by an exogenous increase in investment demand seems inconsistent with the
failure of long-term interest rates to rise near late 1990s levels in the mid-2000s. However, it is
emphasised how this increase in global savings starting in 2003 plays out largely after the period
discussed by Bernanke in his speech on the global saving glut. Obstfeld and Rogoff (2009) thus
propose the following interpretation:
“In our view, the dot-com crash along with its effects on investment demand, coupled
with the resulting extended period of monetary ease, led to the low long-term real interest rates
at the start of the 2000s. However, monetary ease itself helped set off the rise in world saving and
the expanding global imbalances that emerged later in the decade. Indeed, it is only around 2004
that the idea of a global saving glut (as opposed to a global dearth of investment) becomes most
plausible.” 48
The same argument is proposed by Zhou Xiaochuan (2009) and Fiorentini (2011) with
reference to the relationship between the US and China, its largest export partner. Similarly to
what discussed above, it is stressed how a close relationship between the high Chinese net saving
rate and the low US rate should emerge. However, it is found that in the US the saving rate actually
started to decline before the surge in the Chinese current account surplus. Indeed, while the US
savings as a ratio to GDP peaked at 21.3% in 1998 and then started to decrease, it was only in 2001
that the Chinese current account surplus began to soar. As a conclusion, the global saving glut
hypothesis doesn’t seem to be fully and consistently supported by real data.
An exact time correlation between the surge in global savings and the decrease in global
long-term real rates and US saving rate cannot be found. To synthetize, global savings began to
rise only in 2002, two years after the start in the downturn trend in US long-term real interest
rates and four years after the start of the same trend in US savings and exports. However, other
considerations on timing could be brought in support of Bernanke’s view. As highlighted in the
previous chapter, even if world savings were overall still decreasing, starting from 1998 a
consistent group of countries began running sizeable current account surpluses. The East Asian
developing and newly industrialized countries began doing so in 1998 and the oil exporters a year
later. Even if Chinese savings began to drive up in 2001, it’s since 1998 that China systematically
run current account surpluses. Thus, even if not yet displayed in aggregated saving/investment
world data, the shift in patterns of saving and investment – that is, the trend of increasing
polarization between saving and deficit countries – was already beginning to show up some years
47 Obstfeld and Rogoff (2009), p. 149. 48 Ibid., p. 150.
38
before 2002. Moreover, data on the US real effective exchange rate clearly show that the REER
began to increase in 1997, suggesting a correlation between savings in the surplus countries and
deterioration of the US balance through the term of trade channel (see Figure 22).
Figure 22. US’ real effective exchange rate (index, 2005=100), 1980-December 2013
Source: elaboration on Bank for International Settlements data
Nevertheless, also taking as valid a timing in which a saving glut did emerge in a sizeable
group of countries immediately after the Asian crisis, the Bernanke’s hypothesis would not be able
to explain the whole picture, and in particular the economic forces underlying the emergence of
the US current account deficit. As discussed before, Bernanke (2005) argues that the global saving
glut translated in the US deficit through different channels. Before 2000, the higher stock-market
wealth determined a higher willingness of consumer to spend on goods and services and to import
from abroad, and an upward capital investment cycle. After 2000, the low level of real interest
rates fuelled – in particular – the residential investment cycle. However, a look to Figures 14 and
15 in the previous chapter reveals that these trends were already in place far before 1998.
Household savings were experiencing a long-run downward trend started in the mid-1970s.
Even considering a shorter-term perspective, household savings – after being increased
in the five years after the crisis of 1987 – were falling uninterruptedly since 1992. Also the capital
investment dynamic began its upward trend in the early 1990s. The same trend has been followed
by residential investment which, even if having experienced higher rates of growth in 2003-2006,
started an upward trend in the early 1990s. As underlined in the previous chapter, overall the US
current account deficit started expanding in 1991, driven by the dynamic of the private sector
investment. It can be concluded that the global saving glut mechanism – even if actually in force
starting from the end of the 1990s – cannot explain alone the emergence and evolution of current
account imbalances on the side of the United States. A saving glut by the side of China, the East
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Asian countries and the oil exporters can only have contributed to the further widening of the US
current account deficit but not to its emergence.
Other considerations contribute in showing the weakness of the general idea conveyed
by the global saving glut hypothesis – that of a simple passive adaptation by the US economy to
external trends in world savings. Indeed, from a wide number of researches – an overview of which
can be found in Fiorentini (2011) – it does appear that US domestic factors have been as important
as international phenomena in explaining the recent external imbalances of the US economy. From
the previous chapter it does emerge how a downward trend of household savings has been a
persisting feature of US economy over the eighties as well as the nineties and 2000s. Factors which
can contribute to explain the household savings trend comprehend the supply and spread of
financial innovations relaxing individual financial constraints and fostering a rise in consumption
and credit access.49 Such increasing demand of credit-financed consumption can in turn be
explained by rising income inequality in the US – in terms of decline of the share of US average
workers in national income – associated with the desire in maintaining the previous level of
consumption.50 Other explanations of the downturn trend in household consumption refer to the
increase in permanent income generated by an upward trend in productivity associated with
investment in the ICT sector51, the improved economic condition of the elderly reducing the
incentive of youngers to save, and other factors such as demographics, wealth effects and social
security programs. Contributions referred to the consequences of the decade of “Great
Moderation” and macroeconomic stability of the 1990s are as well proposed.52
2.4 The role of the dollar in the international monetary system
As underlined by Fiorentini and Montani (2010), a key ingredient of both the Global Saving Glut
hypothesis and the Bretton Woods II hypothesis is represented by the willingness of emerging
countries to invest their trade surpluses in the US financial market. The two perspectives, however,
differ in the interpretation of the causes of such willingness. In Bernanke’s view, the emerging
countries are happy to invest in the US due to the superior performance – in terms of better
investment opportunities and levels of return – offered by the US assets. This assumption,
however, is not supported by actual data. As discussed in the following chapter (to which please
refer for a deeper analysis) US assets held abroad do not provide foreign investors with higher
returns in comparison with what enjoyed by US owners of foreign assets. On the contrary, the US
is capable of systematically earning an excess return on its external assets than on its liabilities.
According to the Bretton Woods II hypothesis, foreign countries invest their excess
savings in the US’ financial market in that they need collateral that is well accepted by international
49 Marquis (2002). 50 Rajan (2010). 51 Marquis (2002). 52 Guidolin and La Jeunesse (2007).
40
lenders. In an essay published in 2007, Dooley, Garber and Folkerts-Landau deepen this argument.
International collateral, it is argued, needs to have several characteristics. First, “it cannot itself be
borrowed by a sovereign that wants credit” for borrowed international reserves held by a net
debtor government “cannot themselves support gross capital flows because they will evaporate
instantly during a crisis and losing them imposes no net penalty on a defaulting country”. Second,
international collateral “must be the asset of a government or quasi-government organization
because this is the only class of assets the US has seized or frozen”. Third, “it must be held in the
US, preferably in the form of registered US Treasury securities” because “the US actually seizes
foreign sovereign assets, even in geopolitically threatening circumstances”. This last point in
particular has been the object of a great number of critiques. In this regard, Dooley, Garber and
Folkerts-Landau argue:
“Our view is that a substantial part of the US current account deficit supports an
accumulation of collateral to cover the sovereign risks surrounding the FDI flowing into e.g. China.
Several observers have argued that this does not fit the facts because direct investments in China,
for example, are primarily from non-US investors in China. Why, they argue, would a Japanese
investor benefit from collateral held by China in the United States? If collateral is important,
shouldn’t the collateral assets be held in Japan? For the macro, geopolitical expropriation events
that we think are being covered by such collateral, we cannot imagine the government of Japan
seizing Chinese government assets held in Japan. Certainly, the US has a much longer and wider
track record for seizing foreign government assets in the right geopolitical conditions. It follows
that Chinese reserves held in Japan would have little value as collateral." 53
In this perspective, the US government would much more credibly seize and redistribute
collateral than any other sovereign under various geopolitical and internal political disturbances.
The dollar is the dominant reserve currency, it is concluded, because the peculiar characteristics
of US jurisdiction – and not only those of the US currency per se – provide collateral services to
foreign governments. Other commentators underline different features of the international
monetary system which would have granted to the dollar the role of international reserve
currency. One first can be identified in the broad fiscal capacity of the US related to the dimension
of its economy. In addition, Fiorentini and Montani (2010) argue that the dollar has maintained its
central role in the international system even after the end of the Bretton Woods agreement in
1971 due to hysteresis and – even after the birth of the euro – the absence of real alternatives.
Fiorentini and Montani (2010) underline that “as issuer of the de-facto international
currency, the US is able to borrow from abroad by issuing assets in its own currency” and that “a
consequence of the capability of borrowing in domestic money is that the debt burden does not
depend on exchange rates”.54 On the contrary, since US external assets are mostly denominated
53 Dooley, Garber and Folkerts-Landau (2007). 54 Fiorentini and Montani (2010), p. 15.
41
in foreign currencies while US external liabilities are mostly denominated in dollars, any dollar
depreciation actually improves the US net foreign asset position and gives rise to wealth transfer
from the rest of the world to the US. For a discussion of this phenomenon, known as valuation
effects, please refer to the next chapter. What is important to note at this point is that the
asymmetric nature of the international monetary system does allow the US – the country whose
currency is worldwide accepted as reserve currency – to avoid normal balance of payment
constraints. On the contrary, the US has been capable of exploiting the phenomenon of
seignorage: as in Fiorentini and Montani (2010), “insofar as the rest of the world is willing to accept
the key role of the dollar, the US can gain foreign real resources simply in exchange of domestic
money” contrary to all other countries which “have to export something in order to obtain the
foreign currency they need to pay for their imports”.55 This point is a fundamental one in
understanding how was the US capable of sustaining long-lasting current account deficits and thus
having a deeper understanding of the overall causes of the emergence of global imbalances in the
pre-crisis years.
2.5 Interpretations of global imbalances: a critical evaluation
2.5.1 The role of the United States’ monetary policy
It is not strange at all to find some of the major representatives of the US public establishment –
the former Chairman of the Federal Reserve and former Treasury Secretary – sustaining a thesis
that aims to put all the responsibilities of global imbalances on the shoulders of countries other
than the US. However, as discussed above, a thesis in which the role of the US is limited to that of
passive adaptation to external trends doesn’t seem to be convincing, neither it seems to be fully
supported by the available data. The global saving glut hypothesis has a strong political dimension
in ascribing the main responsibility for imbalanced patterns of world balances of payments to
surplus countries, while neglecting or minimizing the role played by the US. It doesn’t propose a
satisfactory explanation of the willingness of the US to accept the financial flows originating in the
surplus countries, nor a discussion of the ways in which use has been made of such financial flows
in the years preceding the global crisis. I’d rather consider the approach proposed by Obstfeld and
Rogoff (2009) to be sharable, in that it implies that the GSG hypothesis can explain one part of the
whole picture – and even a significant one – but should be placed in a broader explanation of the
phenomenon of global imbalances.
Obstfeld and Rogoff (2009) report the Fed’s monetary stance, global real interest rates,
credit market distortions, and financial innovations among the important co-determinants of the
“toxic mix of conditions making the US the epicentre of the global financial crisis”.56 Financial
deregulation should be added to this list. It constituted in a series of legislative provisions which –
55 Ibid., p. 16. 56 Obstfeld and Rogoff (2009), p. 145.
42
in complete independence from the emergence of the saving glut – contributed to sow the seeds
of the crisis. In this regard, particularly significant steps were the Gramm-Leach-Bliley Act (which
in 1999 repealed the Glass-Steagall act of 1933 that had previously separated retail from
investment banking operations), the decision taken in 2000 by the Clinton Administration not to
regulate Credit Default Swaps (CDS), and the decision taken in 2004 by the by the US Securities
and Exchange Commission (SEC) to allow banks to increase their leverage ratio from 10:1 to 30:1.57
The accommodative stance of US monetary policy also played a key role in both the
expansion of housing market excesses and the emersion of global imbalances. As stressed in
Fiorentini (2011), saving surpluses outside the US “would not have been able to cause such a huge
trade deficit had it not been for a policy decision by the Fed to accommodate the rapid growth in
the supply of credit which ultimately led to the sub-prime bubble”.58 The dynamics of the Fed
interest rate is shown in Figure 23. After the dot-com crisis, due to the perception of a rapidly
accelerating weakness in the US economy, the Fed initiated a loosening cycle which brought the
Fed funds rate from the maximum height of 6.5% in May 2000 to a minimum of 1.0% in June 2003,
a level that was maintained for one year.
Figure 23. US monetary policy rates, 1982-January 2014
Source: elaboration of Federal Reserve Economic Data
57 Dettmann (2011), p. 7. 58 Fiorentini (2011), p. 14.
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Cutting interest rates during a recession to stimulate the economy is the usual utilization
of monetary policy that is adopted in the aftermath of a crisis – in this case, the dot-com bubble.
The question thus is not why the Fed did adopt a loose monetary stance in 2000-2001, but why
did maintain it for so long that contributed to a further bubble in the housing and financial
markets. The deflationary effect of the integration in the world market of huge workforce stocks
is identified by Yueh (2013) as a major factor shaping the context for this policy choice:
“The global economy fundamentally changed […] with the takeoff of the open door
policy in China in 1992, the switch to export-oriented from import-substitution policies in India
after its 1991 balance of payments crisis, and the re-joining of Eastern Europe after the fall of
Communism in the former Soviet bloc at the start of the 1990s. These nations together doubled
the global labour force to three billion people, which effectively halved the capital-to-labour ratio
in the world. This led to falling wages and therefore lower prices, including the cost of imports into
rich economies. The deflationary effect, particularly of China with its 700 million labourers, meant
that inflation was low throughout the 2000s whilst growth was strong and thus allowed interest
rates to stay low in the West. Capital was cheap both in terms of price and also in returns given
the additional labour in the global. […] With the focus on inflation and maintaining price stability,
the Federal Reserve did not act to raise interest rates because inflation was low.” 59
Lower dollar depreciation and lower imported inflation affected the incentive for the US
to adjust its policy mix: the Fed not had to suffer the pressure to raise interest rates and was
relieved of the need to choose between price stability and monetary policies to spur growth and
employment. Anyhow, the fact that the choice carried out by the Fed was a fully conscious and
informed one should be further stressed. In 2003-2004, Bernanke was a member of the Board of
Governors of the Federal Reserve. Although fully aware of the risks implied by a low level of the
interest rates on the internal equilibrium and in particular on the housing market – as discussed
above, this clearly appears in the first Bernanke’s speech on the global saving glut – the Fed still
decided to maintain an expansionary stance for an extended period. Thus, even if global factors
have undeniably played an important role in laying the ground for the emergence of global
imbalances, a large part of responsibility has to be borne – likewise – by the US side, namely by its
policymakers, at least for the decision to do nothing to oppose this trends and rather to enable
the US economy to take full advantage of them, regardless of the possible adverse consequences.
Considering the behaviour and choices of US policymakers amongst the principal
determinants of the global crisis is one of the key messages conveyed by the Financial Crisis Inquiry
Commission – leaded by Phil Angelides – in its Final Report published in 2011. The first conclusion
of the report is that the financial crisis “was avoidable […] and the result of human action and
inaction”. Deficiencies by the side of the Federal Reserve are particularly stressed:
59 Yueh (2013), p. 32.
44
“Despite the expressed view of many on Wall Street and in Washington that the crisis
could not have been foreseen or avoided, there were warning signs. The tragedy was that they
were ignored or discounted. […]The prime example is the Federal Reserve’s pivotal failure to stem
the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending
standards. The Federal Reserve was the one entity empowered to do so and it did not.” 60
Also the role of capital inflows to the US is taken into consideration, but it is considered
to be – to put it in mathematical terms – a necessary but not sufficient condition for the
development and the burst of the speculative bubble. It can be concluded that if it’s true that
global imbalances can’t be considered the immediate cause of the crisis, it’s true as well that they
created the conditions for its development. Capital inflows into the United States – and the
resulting low level of real interest rates – affected the US economy in various ways: they allowed
the US to finance their deficit easily and thus fuelled a credit boom; they contributed to depress
mortgage rates and thus boosted investment in the housing sector; they contributed to increase
long-term asset value and household wealth, this in turn increasing household spending; they led
to a search for yield encouraging investors to buy riskier assets.61 However, global imbalances
could only unfold their negative effects in connection with a deregulated US financial sector.62 In
this regard, in the FCIC Report the potential of capital to be used in different ways – that is, to be
invested in different sectors – is stressed:
“[…] in our report, we outline monetary policies and capital flows during the years
leading up to the crisis. Low interest rates, widely available capital, and international investors
seeking to put their money in real estate assets in the United States were prerequisites for the
creation of a credit bubble. Those conditions created increased risks, which should have been
recognized by market participants, policy makers, and regulators. However, it is the Commission’s
conclusion that excess liquidity did not need to cause a crisis. It was the failures outlined above—
including the failure to effectively rein in excesses in the mortgage and financial markets—that
were the principal causes of this crisis. Indeed, the availability of well-priced capital—both foreign
and domestic—is an opportunity for economic expansion and growth if encouraged to flow in
productive directions.” 63
The adverse role of US monetary policy is highly emphasized in what Wolf (2008) calls
the money glut view. In this perspective “the world’s savers are passive victims, profligate
Americans are agents of the imbalances, and the Federal Reserve is an antihero”.64 The argument
can be synthetized this way. The Fed’s monetary excess caused low nominal and – given the
subdued inflationary expectations – real interest rates. This in turn fuelled a rapid growth of credit
60 FCIC (2011), p. xvii. 61 Dettmann (2011), p. 11. 62 Ibid., p. 26. 63 FCIC (2011), p. xxv. 64 Wolf (2008), p. 109.
45
to consumers and a collapse in household savings. The excess US spending, flooded across the
frontiers, generated a huge trade deficit and a corresponding outflow of currency. The latter in
turn resulted in upward pressures on foreign currencies, which were resisted by countries pegging
their currency to the US dollar by means of accumulation of foreign-currency reserves. Wolf (2008)
concludes that “in this view of the world economy, savings are not a driving force, as in the saving
glut hypothesis, but a passive result of excess money creation by the system’s hegemonic
power”.65 Wolf (2008) rejects this interpretation, arguing that monetary growth in the US was not
unreasonably high in the considered period, neither were inflationary expectations. Moreover, he
argues that “it is hard to believe that the soaring savings in Asia and the oil exporters are passive
responses to excess demand from outside, rather than deliberate choices” and that “pegged rates
themselves are policy choices”.66 We agree with this evaluation and believe that the saving glut
that emerged in the surplus countries was primarily an endogenous product of the growth strategy
followed by those countries themselves, together with the consequences of structural –
demographic and economic – developments.
2.5.2 The lost-lost side of the Bretton Woods II framework
If it is implausible – as underlined above – that the saving glut in the surplus countries is a passive
response to excess demand or a money glut from outside, it is as well implausible – as discussed
before – that the US were forced to accept capital from abroad and unwillingly adapted their
economy to the saving glut. In this regard, the framework proposed by the Bretton Woods II
hypothesis effectively describes a situation in which both the saving countries and the US
benefited from their commercial and financial relationship. In this perspective, the international
monetary system was based on a mutual benefit for the US and the trade account region – and
China firstly – in which the former easily financed its deficit and further postponed its external
adjustment, while the latter maximized the opportunity of an export-led growth strategy through
currency devaluations, financed its major exporting market and, at the same time, assured itself
against the risk of a financial crisis. Summarizing, both the US and China enjoyed from the swap
between Chinese export and financing of the US debt.
However, this win-win approach does represent only one side of the coin and hide the
other one, which represents what could be called the “lost-lost side”. Indeed, if it’s true that the
US and China benefited from their mutual relationship, it’s as well true that from this same
relationship dangerous consequences arose for both. By the side of the debtor, the increasing
dependence of the US from China with respect to debt financing obviously does condition the
former and limits its possibilities of intervention against the increasing role of the latter in the
international economic and politic arena. In this perspective, the US is weakened by its debtor
stance while China can take full advantage of its rising trend. However, from the point of view of
65 Ibid., p. 110. 66 Ibid.
46
the creditor, the greater is the size of US debt being financed, the greater are the risks deriving
from a devaluation – or even a currency crisis – of the dollar. In other words, alongside with the
increase of the debt, the dependence of the debtor eventually does trap also the creditor, as in a
famous quote from John M. Keynes: “If you owe your bank a hundred pounds, you have a problem,
but if you owe a million, it has”.67
In this regard, prior to the global crisis many commentators highlighted the risk of a
sudden stop of capital flows sustaining the dollar and a strong devaluation of the latter. Thus, a
blackmail is placed by the creditor to the debtor as well as in the opposite direction. Indeed China
and the other countries pegging their currency to the dollar and accumulating dollar-denominated
reserves are forced to continue sustain the international currency – and the commercial and
financial relationship with the US implied in this framework – to support the value of their own
asset stock. In this regard, Beardson (2013) highlights the fact that Chinese holdings of US
securities are so large that “if Beijing decided to stop renewing them, it could negatively affect the
value of their remaining holdings, the dollar and the US financial system”. Beardson (2013)
underlines that though China seems to be enviably positioned with regard to foreign-currency
reserves, owning so much foreign currency determines on the contrary a high level of vulnerability
in terms of exchange rate exposure:
“[…] for China, with its potentially rising currency, to borrow domestically in order to
place $3 trillion in someone else’s – uncontrolled and potentially falling – currency makes it highly
vulnerable. Taking such a large “minority stake” in an insufficiently diversified portfolio with
unhedged currency exposure breaks many basic investment rules. It makes a country weaker, not
stronger.” 68
Not only does the mutual relationship inherent in the Bretton Woods II world entail a
structural “lost-lost” relationship, as discussed above. It also leaves plenty of room to the
emergence of numerous “bad consequences”. In other words, from considering the structure of
Bretton Woods II as one characterized by a medium-term or even long-term potential for
sustainability, it does not follow that this structure is a safe one. On the contrary, the structure of
Bretton Woods II has given way – and even contributed – to the development of a financial
environment characterized by a high level of hazardousness which has eventually fully displayed
itself in the outbreak of the crisis. In 2009, the same Dooley, Folkerts-Landau and Garber – though
defending the overall correctness of their model – did admit to have underestimated the
shortcomings inherent in their approach:
“Our mistake, and it was a serious one, was in not recognizing the absolute necessity for
large swaths of the financial system to continue earning higher yields and the speed with which
67 As quoted in The Economist, 13 February 1982, p. 11. 68 Beardson (2013), p. 118.
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these institutions would find imprudent and dishonest ways to get those yields. We also failed to
foresee failures in prudential supervision and regulation that encouraged increased leverage
outside the traditional banking system and made the system vulnerable to a general run with a fall
in asset values via fire sales. Specifically, we did not expect a global panic to strike so completely,
destroying all asset pricing models by blocking the flow of credit.” 69
It can be concluded that the Bretton Woods II hypothesis can be regarded as a useful
description of the framework of mutual interests that shaped the international financial and
monetary system in the years before the crisis. However, this approach fails in considering the
high costs which are the direct consequences of this framework. As in Fiorentini and Montani
(2010), the costs of the mutual relationship between the US and the emerging countries has been
fully displayed in the aftermath of the international crisis, and it’s represented by a situation in
which “excessive domestic and external debt in the American economy” finds its counterpart in
“excessive reliance on the US market by developing countries”. This mutual relationship is “the
main reason for the rapid worldwide spread of the US recession”.70
69 Dooley, Folkerts-Landau and Garber (2009). 70 Fiorentini and Montani (2010), p. 17.
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49
Chapter 3. Gross financial flows and positions
3.1 Relevance of gross financial flows and positions
A challenging branch of research on global imbalances is focused on the relationship between
current account balances – the traditional “unit of measure” of global imbalances – and gross flows
and asset and liability positions. Many commentators have recently advocated how the focus of
the research – both from the academic and economic policy perspectives – should be shifted from
net balances toward gross measures. Maurice Obstfeld (2012), inter alia, gives a particularly sharp
contribution to the debate. His reflection starts from the observation that most discussions on
global imbalances – even high-level ones – frequently focus on current account imbalances only
and miss a proper analysis of nature, dimension, and evolution of the complex multilateral
patterns of the gross financial flows that finance such imbalances.71
Figure 24. US financial account gross flows (ratio to GDP), 1970-2012
Source: elaboration on Bureau of Economic Analysis data
Gross financial flows toward and from the US have grown rapidly starting from the early
1990s. This is evident, for instance, looking at the US financial account, shown in Figure 24. Each
year the financial account balance is given by the sum of US residents’ net purchases of foreign
assets and foreign resident’s net purchases of US assets. In order to evaluate the magnitude of
these gross financial flows, it is useful to compare them with the gross flows recorded in the
current account: export, import and income receipts and payments, reported in Figure 25. Over
the 1970s and 1980s gross financial flows were much smaller than trade flows: on average,
71 Obstfeld (2012), p. 3.
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compared with the magnitude of exports and imports of goods and services, financial flows were
only tantamount to 26% in the 1970s and 33% in the 1980s. In the following decades, and
particularly in the second half of the 2000s, the size of financial flows has grown, to reach in the
pre-crisis years a magnitude similar to that of trade flows (91% of exports and imports in 2006,
and 88% in 2007).
Figure 25. US current account gross flows (ratio to GDP), 1970-2013III
Source: elaboration on Bureau of Economic Analysis data
Figure 26. US gross asset and liability positions and NIIP (ratio to GDP), 1976-2012
Source: elaboration on Bureau of Economic Analysis data
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This grow in gross financial flows is reflected in the concurrent increase of US asset and
liability stocks positions, shown in Figure 26. At the beginning of the series, in 1976, assets were
equal to 24% of GDP and liabilities to 16%, thus the US was a creditor country. The small relative
dimension of gross claims and liabilities reflected the large direct and indirect costs of cross-border
financial transactions.72 In 1986 the size of liabilities overtook that of assets at the level of 32% of
GDP. These stocks increased to reach 60% and 74% of GDP in 2000. In the first half of 2000 asset
and liability positions exploded, to reach 132% and 154% of GDP in 2008, and 139% and 163% of
GDP in 2011. Gourinchas and Rey (2013) updated previous works73 with reference to a number of
major countries, and confirmed how cross-border gross flows and asset and liability positions have
massively increased since the 1980s and especially in the 1990s and 2000s. They found, also, that
this increase has been particularly pronounced for advanced economies.
A first – highly justified – concern about gross financial flows relates to increased threats
to global financial stability. Since gross financial flows are found to overshadow the net flows
measured by the current account balance, Obstfeld (2012) concludes that the stability impact of
the latter per se is small compared to that of the gross flows that finance international financial
transactions. In this perspective, it’s the gross exposure that seems to carry the risk of financial
instability – of a balance sheet crisis – regardless of whether the country has a current account
deficit or surplus, or is a net international creditor or debtor. In this regard, the author provides
the reader with an example of how gross financial flows played a major role in laying the
groundwork for the recent global crisis. The case under consideration refers to the large position
in AAA-rated US asset-backed securities taken by European banks. Obstfeld (2012) argues:
“Although extensive, this business received relatively little attention in policy circles
compared with the flows of emerging markets’ excess savings into US Treasury securities and
agency obligations. But the flows from Europe played a key role in US credit growth, including
housing finance. Banking inflows to the US originated in current-account deficit countries (the
United Kingdom) and surplus countries (Germany, Switzerland) alike.” 74
Obstfeld (2012) concludes that the tremendous tension borne by European banks during
the crisis were felt by banks in current account surplus and deficit alike because the banks’ intrinsic
vulnerability originated in the gross positions on their balance sheets, which were largely exposed
toward toxic US asset-backed securities.
72 Gourinchas, Rey, and Truempler (2012), p. 266. 73 In particular, Lane and Milesi-Ferretti (2001) and Lane and Milesi-Ferretti (2007). 74 Obstfeld (2012), p. 20.
52
3.2 Valuation effects
3.2.1 Net international investment position and current account balance
Other important considerations can be derived from the observation of the relationship between
the international flows of capital reported in the balance of payments data and the stocks of
foreign asset and liabilities. This involves the definition and interpretation of the net international
investment position (NIIP). The NIIP – reported also in Figure 26 – is equal to the difference
between the value of foreign assets owned by US residents and the value of US assets owned by
foreigner residents, which are liabilities from the point of view of the US. The dynamics of the NIIP
is governed by the following equation, where KGA and KGL represent changes in the nominal
market values of foreign assets and liabilities, namely capital gains due to exchange rate and other
asset price movements:
(1) NIIPt = NIIPt-1 + CA + KGA – KGL
The key economic significance of the NIIP is that at any point in time, it limits the present
value of a country’s future net export deficits, thus representing a national constraint governing a
country’s feasible transactions with foreigners.75 This perspective entails important consequences
for a country with respect to the compliance with the intertemporal budget constraint and the
dynamics of external adjustment. In addition to the traditional trade channel of adjustment –
whereby current account deficits have to be offset by future export surpluses – the valuation
channel of adjustment must be taken into consideration. Capital gains and losses on the net
foreign asset position due to fluctuations in asset prices and exchange rates can largely contribute
to the external adjustment of a deficit country.
As documented and discussed by many commentators, in recent years the current
account balance has become an increasingly minor component of the overall change in the NIIP,
and its impact on US net external wealth have been dwarfed by capital gains and losses on
increasing gross foreign asset and liability positions.76 Figure 27 shows a comparison of the NIIP
and the series that can be obtained cumulating the US current account balances to the net
international investment position of 1976. This exercise returns a well-known – but anyhow
astonishing – result: while the cumulative current account deficit series was equal to 78.2% of GDP
in 2012, the net liability position only amounted to 23.8% of GDP. Thus the US over the considered
period enjoyed huge net capital gains on its net external asset position, which are known in the
literature on global imbalances as valuation effects.77 The role played by valuation effects has been
crucial especially in the years before the crisis: in the period 2001-2007 the cumulative current
account deficit worsened by $4,254 billion while the NIIP actually improved by $79 billion. As
stressed in Wolf (2008), at the very time when its current account deficits were particularly large,
75 Obstfeld (2012), p. 8. 76 See, as instance, Obstfeld (2012), p. 22. 77 See, as instance, the pioneering work of Lane and Milesi-Ferretti (2001).
53
valuation effects were particularly favourable to the US, thus the US was able to borrow historically
large amounts without any deterioration in its NIIP.78
Figure 27. Cumulated current account and NIIP (ratio to GDP), 1976-2012
Source: elaboration on Bureau of Economic Analysis data
The existence of valuation effects is found also with reference to other economies,
although often in smaller proportions. The BRIC economies are found to have experienced
significant cumulated valuation losses since 2000, between 10% of output for China and 40% for
Russia. In general, there is evidence of an asymmetry between the US – which have enjoyed large
positive valuation gains prior to the crisis – and emerging economies, which conversely have
suffered large valuation losses. For most countries, including the emerging economies, the
importance of valuation effects is found to have grown over time. As a consequence, the average
magnitude of current accounts, though rising over time, tends to be dominated by the average
magnitude of valuation effects. 79
3.2.2 Components of valuation effects
Gourinchas and Rey (2013) estimate the average size of valuation effects enjoyed by the US in
about 2% of GDP for every year between 1970 and 2010. In the US, the magnitude of valuation
effects has increased over the years, both in absolute terms and relative to the size of net financial
flows. This has happened also because of the huge ratio of assets and liabilities to GDP, which has
been increasing in recent years and have magnified the effects of valuation changes. Figure 28
shows the total financial flow to the US to cover its current account deficit in each year between
78 Wolf (2008), pp. 126-127. 79 Gourinchas and Rey (2013), p. 8.
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54
1989 and 2012. The sum of those net flows and the changes in valuations represents the change
in the NIIP. In some years – as in 2005, 2007, 2009 and 2010 – valuation effects have been so great
to be able to determine positive changes in the NIIP even in the presence of negative net financial
flows. In 2005, for instance, a net gain of $1,022 billion turned a net financial inflow of $701 billion
into a positive change in the NIIP of $321, thus in a gain to the US. In 2008 and 2011, however,
valuation effects have had a negative impact on the NIIP, causing a deterioration in net liabilities
wider of what it would have resulted in their absence. In 2008, a net loss of $734 billion added to
a net financial inflow of $731 billion and resulted in a change in the NIIP of $1,464 billion, equal to
10% of GDP.
Valuation effects are recorded in the NIPA financial statements as divided in three
components: asset price movements, exchange rate movements, and so-called “other changes”.
Some considerations can be made on the role played over the years by these three components.
A relative price movement on US asset relative to liabilities represents – when positive – a better
price performance of assets owned by Americans abroad than of US assets owned by foreigners.
Asset price movements have represented a substantial component of valuation effects if we
consider their size. Over the period 1989-2012, price movements have accounted for half of the
total valuation movements in absolute value. However, this first component has been a very
volatile one and has alternated positive and negative contributions to the overall change of the
NIIP.
Figure 28. Financial flows and change in US NIIP (ratio to GDP), 1989-2012
Source: elaboration on Bureau of Economic Analysis data
-10%
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As a consequence, taking the cumulated series of price movements, it does emerge that
their role in explaining the gap between the NIIP and cumulated current account balances is not
that important. Up to 2004, the series of cumulated price movements has been always negative –
thus worsening the NIIP and not improving it – and not larger than 3% of GDP. It’s only from 2005
that price movements have played a major role in countering the worsening of the NIIP: over the
three years from 2005 to 2007, positive price movements accounted for 10% of GDP. Thus in the
years immediately before the crisis price effects highly contributed to overall capital gains. After
the crisis, however, large positive price movements (in 2009, 2010 and 2012) alternated to large
negative ones (in 2008 and 2011). At the end of the period, asset price movements accounted for
20% of the total gap between the NIIP and cumulated current account balances (see Figure 29).
Exchange rate changes have been a minor component of total changes over the whole
period. On average they have represented one third of the total valuation movements and – as
price movements – have been very volatile over the years, alternating positive and negative
contributions to the dynamics of the NIIP. Meissner and Taylor (2006) also share this view and
argue that that the exchange rate channel is a weak explanation of valuation effects in the long
run. Until 2001, negative exchange rate movements have been worsening the NIIP. In the period
between 2002 and 2007, however, they have given an important and positive contribution. Over
this period exchange rate changes have accounted to almost one third of the process of
international adjustment brought by valuation changes. This positive effect has been produced by
the strong US dollar real depreciation that has taken place from 2002 onward (see Figure 23 in
Chapter 2). After the crisis – and particularly in 2008 – exchange rate changes have returned to be
negative. At the end of the period, this component accounted for 6% of the total gap between the
NIIP and cumulated current account balances.
Valuation changes due to other changes represent a major component. Other changes
can represent either mismeasured or unrecorded capital gains/losses (as is assumed in Gourinchas
and Rey (2007)), unrecorded or mismeasured financial flows (as in Curcuru et al. (2008) and Forbes
(2010)), mismeasured initial net asset position, or any combination thereof. Although these
valuation changes have represented on average only one fifth of the absolute value of all valuation
movements, valuation changes due to other changes have always been positive over the whole
considered period (with the exception of years 2006, 2011 and 2012 only). Thus, their overall
contribution to the improvement of the NIIP vis-à-vis the dynamics of cumulated current account
have been increasing year after year. As shown in Figure 29, at the end of the period valuation
effects due to other changes accounted for 74% of the total gap between the NIIP and cumulated
current account balances.
Figure 29. Change in NIIP and cumulated components of valuation effects (ratio to GDP)80, 1988-2012
80 In this Figure the series of cumulated financial flows is different from that reported in Figure 27 because current account deficit are cumulated starting from 1988 instead of 1976.
56
Source: elaboration on Bureau of Economic Analysis data
Figure 30. Asset and liabilities flows and valuation effects (ratio to GDP), 1989-2012
Source: elaboration on Bureau of Economic Analysis data
It can be concluded that while asset price and exchange rate movements may give an
important contribution in explaining the dynamics of the NIIP in the short term – improvements
or deteriorations of the net position year over year – its long-term trend is mainly explained by
valuation effects due to other changes. As this regard, Meissner and Taylor (2006) argue that the
size of these other changes in the valuation adjustments of the NIIP makes both understanding
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57
what is happening and extrapolation of past favourable outcomes “ill advised”.81 However,
different assumptions on the allocation of other changes between mismeasured valuations,
financial flows or asset positions have not effect on the overall result for which over long period
of times, the US has experienced a higher return on its foreign assets than that foreigners have
enjoyed on US liabilities.82 This is made clear by Figure 30 in which is shown that, while the value
of financial inflows to the US has always been greater than the values of foreign asset purchases
by US residents, positive valuation effects has generally been lower on US liabilities than on US
assets, so as to largely narrow the gap between gross assets and liabilities over the years.
3.3 The United States’ exorbitant privilege
The ability of the US of enjoying wide benefits deriving from the dynamics of its external balance
sheet – in other words, the existence of the huge valuation effects discussed earlier – is known in
literature as the exorbitant privilege.83 The direct consequence of the exorbitant privilege is to
relax the external constraint of the US, allowing it to run large current account deficits without
worsening its external position commensurately. As a consequence, the exorbitant privilege
translates into a soft external constraint.84 The exorbitant privilege is a direct consequence of the
asymmetric structure of the US external balance sheet. A prime element of asymmetry is widely
documented with reference to the currency in which US assets and liabilities are denominated.
While US foreign assets consist in securities, bonds and equity mainly denominated in foreign
currencies, US external liabilities are mostly denominated in dollars.
It follows that any devaluation of the dollar gives rise to wealth transfer from the rest of
the world to the US, and thus improves the US net foreign asset position. As in Wolf (2008), real
exchange rate depreciations are an “elegant, painless, and entirely legal way for the US to
default”.85 Being the US the issuer of the international reserve currency, it does follow that it is
capable to borrow abroad by issuing assets in its own domestic currency, so that the debt burden
does not depend – or does depend in a far lessen way – on the exchange rate. In other words, the
exchange rate exposure, instead of being borne by the US, is shifted to the rest of the world. This
exchange rate channel of the exorbitant privilege is documented and emphasized by many
commentators, among which Dettmann (2011), Meissner and Taylor (2006), Fiorentini and
Montani (2010), Fiorentini (2011).
Figure 31. Income receipts and payments on external assets and liabilities, 1976-2012
81 Meissner and Taylor (2006), p. 4. 82 Gourinchas, Rey, and Govillot (2010), p. 5. 83 As reported by Gourinchas and Rey (2007), the first to use the expression of “exorbitant privilege” was Valéry Giscard d’Estaing, Finance Minister at the time, in February 1965. 84 Dettmann (2011), p. 21. 85 Wolf (2008), p. 128.
58
Source: elaboration on Federal Reserve Economic Data and US Bureau of Economic Analysis data
Other commentators – amongst others, Gourinchas, Rey and Govillot (2010) – refer to
the exorbitant privilege stressing the US ability of earning an excess return on its external assets
than on its liabilities. This is clearly shown by Figure 31, which reports income receipts on US-
owned assets abroad and income payments on foreign-owned US assets relative to the respective
stocks. The ability of the US of earning excess returns on average on its external asset position
allows it to run larger current account deficits that it would otherwise, as the deterioration of the
net international asset position is muted by the capital gains. Excess returns on US external assets
relative to liabilities can be divided into three components. A composition effect results from an
asymmetric structure of the US external balance sheet and is due to the relative proportion of safe
liabilities and risky assets – US external assets are less liquid and more risky than US external
liabilities and therefore earn a premium. A leverage effect does result from the size of the US
external balance sheet itself. In addition to that, a return effect can be observed, that is an excess
return within class of assets.86
Let us first consider the composition effect. The US, as the centre of the international
monetary system, acts as an international liquidity provider, and as such its external balance sheet
displays a very specific pattern: US liabilities are mostly composed by safe and liquid short-term
securities, while assets are mostly composed by risky and illiquid – thus higher yielding – long-term
claims. Being this the traditional maturity transformation of a bank, the US can be seen as the
banker of the world – as in Kindleberger (1965) – and its external balance sheet as a gargantuan
leveraged portfolio.87
86 Gourinchas, Rey, and Govillot (2010), p. 2. 87 Gourinchas and Rey (2007), p. 11.
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59
Figure 32. Composition of US gross external assets, 1976-2012
Source: elaboration on Bureau of Economic Analysis data
Figure 33. Composition of US gross external liabilities, 1976-2012
Source: elaboration on Bureau of Economic Analysis data
Figures 32 and 33 report the breakdown of gross asset and liabilities into portfolio equity
and debt, direct investment, bank loans and other assets. The figures highlight how the
composition of US assets and liabilities has changed over time. In 1983, half of these cross-border
positions took the form of bank loans. Most (66%) of the remaining assets were direct investment,
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while remaining liabilities were mostly composed by both direct investment (41%) and debt (39%,
almost entirely foreign holdings of US government securities). Twenty-five years later, in 2007, the
structure of the rest of the US external balance sheet was largely changed. Cross-border loans
decreased their weight to almost 30% of all cross-border positions (. Direct investment accounted
for one fourth of remaining external claims, the other part being mainly composed by equity
holdings (40%) and financial derivatives (almost 20%). With reference to liabilities, debt
instruments accounted for 46% of liabilities other than bank loans, but holdings of US government
securities represented only half of that amount. The other half included corporate debt and
structured credit instrument such as US mortgage-backed securities.88 Moreover, from Figures 32
and 33 the role assumed by financial derivatives in the last decade, both before and after the crisis,
does clearly emerge.
Not only the specific characteristic of the US external balance sheet – the US is short in
safe and liquid securities and long in risky and illiquid ones – and the resulting overall pattern of
liquidity transformation have persisted over time89 but this characteristic has become even more
pronounced. The share of safe and liquid securities (bank loans and debt instruments) on total US
external liabilities has remained stable at about 70% until the mid-1990s, then has decreased to
an average level of 62% in the 2000s. The share of risky and illiquid assets – direct investment and
equity – on total US external claims has followed a different pattern. Starting from about one third
in 1983, it has constantly increased, to reach almost 60% before the dot-com crisis and 65% in
2008 and 2012 (see Figure 34). Thus, while the composition of liabilities broadly remained the
same, the composition of assets was progressively shifted from long-term lending to FDI and
equity. The US changed from being the world banker to be the world venture capitalist, as argued
by Gourinchas and Rey (2007). This shift in asset composition could account in large measure to
the explanation of the large capital gains enjoyed by the US in recent years.
The pattern of liquidity transformation realised by the US financial market has magnified
over time, inasmuch as, starting from the mid-1980s, the overall composition of US external assets
has become increasingly risky, thus the overall leverage ratio of the US external balance sheet has
increased. The positive return differential earned by the US has been exploited over the years by
increasing the leverage ratio and, at the same time, by enlarging the size of the balance sheet (as
a ratio to GDP) more than six times in the three decades between the end of the 1970s and the
end of the 2000s. This can be interpreted as a leverage effect contributing to the overall dimension
of the US exorbitant privilege. In this way, the US has been capable of offsetting the downward
trend in yield differentials that – according to Meissner and Taylor (2006) – has started at the
beginning of the 1980s.
88 Gourinchas, Rey, and Truempler (2012), p. 266. 89 As underlined in Gourinchas, Rey, and Truempler (2012), see p. 267.
61
Figure 34. Risky/illiquid assets and safe/liquid liabilities (ratio to total assets and liabilities), 1976-2012
Source: elaboration on Bureau of Economic Analysis data
To these effects a third one – the return effect – does add. It has been found that a
sizeable share of excess returns does not come from a composition effect but rather from a within-
asset-class differential.90 US bonds held by foreigners, for instance, give a lower total return than
foreign bonds owned by US residents. In order to understand the causes of this differential, a
qualitative analysis of the asset typology held by the US financial institutions should be considered.
This brings us back to the financial deregulation which took place prior to the crisis and – as
underlined in FCIC (2011) – was particularly exploited by “the large investment banks and bank
holding companies, which focused their activities increasingly on risky trading activities that
produced hefty profits”. These banks and companies “took on enormous exposures in acquiring
and supporting subprime lenders and creating, packaging, repackaging, and selling trillions of
dollars in mortgage-related securities, including synthetic financial products. Like Icarus, they
never feared flying ever closer to the sun”.91
90 Gourinchas and Rey (2007), p. 12, and Habib (2010), pp. 24-28. 91 FCIC (2011), p. xix.
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63
Chapter 4. Adjustment in global imbalances
4.1 Adjustment in current account imbalances
As discussed in the previous chapters, most of the literature on global imbalances – as they
emerged in the pre-crisis period – reported a narrative of the early 2000s up to the global crisis in
which the sharp increase in the dispersion of current account balances was related to a financial
environment characterized by low global interest rates, increased risk tolerance among global
investors and increased risk taking among deficit countries. Even if it was often recognized that
current account imbalances had a non-sustainable component during this period, it was as well
pointed out how such component was due for elimination once the froth in credit market would
have dissipated.92 Most commentators indeed recognized the need for global imbalances to go
through a period of adjustment. The discussion revolved around the modalities that such an
adjustment would have taken, where the possibility of a “sudden stop” of international capital
flows and a drastic fall in the level of current account imbalances was opposed to the – much less
painful – chance of a gradual adjustment. In this regard, Steven Dunaway of the Council on Foreign
Relations traces the economic mechanisms that – in what is defined a “normal” economic and
financial environment – are triggered by imbalances in current account and either force them to
adjustment or work to maintain them at a sustainable level. Deficit countries face increasing
pressure in obtaining financing, and this fosters adjustment through upward pressure on domestic
interest rates, downward pressure on the real exchange rate, and slowing domestic economic
activity. Surplus countries face similar pressures in the opposite direction, where the main forces
prompting the adjustment of the balance of payments can be identified in the rising economic
activity and the appreciation of the real exchange rate.93
However, being the international monetary system very different from what could be
defined a “normal” environment, in the decade before the global crisis both deficit and surplus
countries were able to largely postpone the time of adjustment in their respective external
position. Dunaway (2009) identifies three main features of the international financial system that
facilitated the growth of current account imbalances and – at the same time – allowed countries
to delay dealing with them. The first refers to the fact that a country that issues reserve asset can
finance current account deficits for an extended period. The second is that a country facing upward
pressure on the value of its currency can manage its exchange rate to resist such pressure and
delay adjustment in its balance of payments. The third is that, for countries with floating exchange
rates, a depreciating currency can provide a sheltering effect that can diminish pressure for
structural adjustment. It’s easy to identify which country or region has respectively taken
advantage of these three features:
92 Lane and Milesi-Ferretti (2011), p. 6. 93 Dunaway (2009), p. 7.
64
“The United States has taken advantage of its position as the primary issuer of reserve
assets to finance a growing current account deficit during the 2000s. East Asian emerging market
economies in general, and China in particular, have taken advantage of the second feature of the
system. They have resisted upward pressure on their currencies and run large current account
surpluses. Japan and Europe have made use of the third feature. Weaknesses in the value of the
yen and the euro in the late 1990s and early 2000s contributed to the slow pace and inadequacy
of structural reforms in labour and product markets, slowing economic growth and contributing
to global imbalances.” 94
It’s worth deepening these arguments with reference to the first two features of the
international monetary system, describing the relationship between US and the Asian countries
and China in particular. The first feature implies that the country which provides reserve assets
can finance a deficit in its external position simply by issuing assets in its domestic currency. As
discussed in the previous chapters, rising US current account deficits reflected – in particular in
the early and mid-2000s – booming consumption growth and residential investment, the financing
of which was in large part provided by foreign governments. The cost to the US for this financing
was relatively low because of the premium foreign governments were willing to pay to obtain risk-
free US government securities. This relates to the issue of the exorbitant privilege enjoyed by the
US in the decade prior to the global crisis, for a discussion of which please refer to Chapter 3.
Dunaway (2009) underlines how “the availability of cheap foreign financing [allowed] the United
States to put off painful measures to boost national savings”.95 The need for adjustment thus
remained but the US managed to postpone it to an undetermined future. In the aftermath of the
global crisis, US private savings were eventually forced to increase, and shifted from 16.5% of GDP
at the end of 2007 to 22.5% of GDP at the beginning of 2010.
Let’s turn to the “second feature” of the international monetary system. A surplus
country that manages its exchange rate can resist upward pressure on its currency, given that the
rest of the world is demanding it. The desired level of the exchange rate can be hold intervening
in the market to sell the domestic currency and accumulate foreign-currency reserves. Such
interventions are to be sterilized through domestic monetary policy actions, in order to avoid a
rise in inflation that would otherwise induce a real appreciation of the currency. Policies of
sterilization of exchange rate interventions, however, lead to further consequences. In particular,
the protracted maintenance of an undervalued exchange rate by a country largely contributes in
stunting the development of its domestic financial sector, as effectively summarized by Dunaway
(2009):
“There are limits, however, to how long sterilized intervention will work. In particular,
the cost of such intervention in terms of higher domestic interest rates will eventually take its toll
94 Dunaway (2009), p. 4. 95 Ibid., p. 8.
65
on the finances of the central bank and have consequences for the real economy […]. To diminish
some of these consequences, sterilized intervention can be supported by capital controls and
administrative controls over domestic financial markets […]. Imposing capital and administrative
controls is not without cost, given the distortions they create and the repression of the financial
system that tends to occur.” 96
It’s easy to recognize in the description of the international financial system proposed by
Dunaway (2009) the world of Bretton Woods II. However, while in the perspective of Dooley,
Folkerts-Landau and Garber the relationship between centre country, trade account region and
capital account region is a fully sustainable one, Dunaway (2009) does underline that the global
imbalances implied in this framework played a major role in creating the global crisis. In his words,
“the seeds of the crisis were sown by the economic policies in those major countries that fostered
global imbalances and by the features of the international financial system that facilitated the
growth of those imbalances”. Were these features not been in place, the adjustment process
would have been more prompt and its effect less painful.
This approach is in line with the broad literature on sudden stops and financial crises.
The basic hypothesis inherent in these contributions is the idea that pre-crisis current account
imbalances had widened beyond levels consistent with sustainable medium-term positions.97 In
these frameworks, widening current account imbalances – having been determined by credit
boom and asset price bubbles, easy external financing conditions, rising oil prices, and other
factors – would have eventually been reversed due to an abrupt change in such conditions:
tightening credit, drying up of external finance for heavily indebted countries, decline in asset
prices and oil prices. An adverse shift in global financial conditions should have eventually resulted
in dramatic narrowing of current account imbalances, with deficit countries experiencing real
exchange rate depreciation and output declines or even collapses. In this regard, Dunaway (2009)
underlines how the relationship between delay in adjustment and size of the adjustment itself can
be found not only with respect to a deficit country – for which it appears as more straightforward
– but also with regard to surplus countries:
“[…] maintaining an undervalued exchange rate imposes large costs on the real
economy. The distortion in the value of the exchange rate will create serious misallocations of
resources in the export- and import-substituting sectors of the economy. The longer an
undervaluation of the currency is maintained, the greater the misallocations created and the more
difficult the readjustment the economy must undergo to unwind the distortion.” 98
Dunaway (2009) concludes that if nothing will be done in the future to address the
features of the international financial system which facilitated the growth of global imbalances,
96 Dunaway (2009), p. 10. 97 See, as example, Lane and Milesi-Ferretti (2011). 98 Dunaway (2009), p. 10.
66
the latter “will simply build up again as the world economy recovers, and in time they will become
a major contributing factors to the next global crisis”. Therefore, it is assumed that current account
imbalances – reflecting large imbalances between savings and investment in the major world
economies – have a strong predictive power with respect to the outbreak of financial crises.
As already discussed, not all commentators agree with such an interpretation. The
previous chapter was aimed to highlight the relevance of gross financial flows and position in
relation to net positions. This kind of argument may elicit the doubt whether the centrality of
current account positions with respect to assessments of financial stability risk does still matter,
or conversely it has been completely outclassed by the role of gross international financial flows.
As discussed before, in Obstfeld (2012) the role of gross exposures in carrying the risks of financial
instability, regardless of net current account positions, is stressed. Nevertheless, Obstfeld (2012)
does identify a number of reasons why it would be still appropriate to worry about current account
balances. In particular, it is underlined how current account imbalances may be interpreted as
symptoms of related problems. However, the evidence in this regard that can be gathered from
the related literature is mixed.
On one hand, numerous commentators point out how net inflows of private capital may
help generate credit booms and – in presence of potentially fragile or leveraged financial systems
– raise the probability of a crash.99 In this perspective, some systematic relationship among current
account deficits, domestic credit growth, and financial crises, should thus be acknowledged. Other
commentators, however, although recognizing to the current account position some predictive
power for currency crashes, underline that the same role has to be attributed to a stronger extent
to other indicators, such as international reserves and real exchange rates.100 Other contributions,
lastly, deny any statistical significant predictive power to current account imbalances.101 An
analysis of the available data on the phenomena of balance of payments adjustment which have
followed the global crisis can surely brought more evidences with respect to this issue.
4.2 Evidences on adjustment after the international crisis
4.2.1 Shrinkage of international current account exposures
In the years following the outbreak of the global crisis, a general trend of adjustment in pre-crisis
levels of current account imbalances has happened. Taking as a proxy of global imbalances the
sum of the absolute value of world current account balances – either surpluses or deficits – it can
been observed how they decreased from a maximum value equal to 5.7% of world GDP in 2006,
to 5.5% in 2007, 5.4% in 2008 and finally crumbling to a minimum value equal to 3.7% of world
GDP in 2009. Subsequently, global imbalances have slightly recovered to about 4% of world GDP
99 Ostry et al (2011), p. 21, and IMF (2011). 100 Frankel and Saravelos (2010), p. 28. 101 Gourinchas and Obstfeld (2012).
67
in the period 2010-2012. It’s important to note how this level is still equal to about the double of
that prevailing in the early and mid-1990s. What have been the trends experienced by the major
countries and country groups already introduced in Chapter 1? Figure 35 shows the dynamics of
current account balances of the US, Japan, China, surplus and deficit countries of Europe, East
Asian emerging and newly industrialized countries, and oil exporters. Surplus countries as a group
shifted their aggregate balance of payment position from a level equal to 2.8% of world GDP in
2006 to 1.8% in 2009, to eventually end at 2.0% of world GDP in 2012. From the side of deficit
countries, the aggregate balance of payment position went from 2.3% of world GDP in 2006 to
1.5% in 2009 and 2012.
Figure 35. Adjustment in current account imbalances, 2006-2018 (previsions start in 2013)
Source: elaboration on IMF World Economic Outlook (October 2013) data
It is worth considering these major countries and country groups one at a time:
The current account deficit run by the US strongly contracted, shifting from $799 billion
– equal to 5.8% of US GDP and 1.6% of world GDP – in 2006 to $440 billion – equal to
2.7% of US GDP and 0.6% of world GDP – in 2012. The deep contraction in 2006-2009
has been due to the combination of a huge drop in private investment (corporate
business -31% in 2007III-2009III, household -56% in 2006I-2010II), a huge drop as well in
government savings (from 1.0% of GDP in 2006IV to -8.2% in 2009III), and an increase in
private savings (corporate business +43% in 2008IV-2010III, household +69% in 2007III-
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2009II). The IMF previsions estimate the US deficit to remain at a broadly stable level in
the period 2013-2018.
The deficit run by the group of deficit countries of Europe has been heavily contracting
as well, shifting from $342 billion – equal to 3.6% of the aggregate GDP of the EU deficit
group and 0.7% of world GDP – in 2006 to $209 billion – 2.0% of the group GDP and 0.3%
of world GDP – in 2012. The IMF provisions for the period 2013-2018 foresee a further
contraction of the external deficit and an eventual shift to a surplus position.
EU surplus countries group’s position has been contracting to a far lesser extent in the
period 2006-2012. The group surplus, equal to $318 billion in 2006, has risen to $363
billion in 2012. Relative to the group’s GDP, this shift represent a decrease from 6.1% to
5.5%. Such position is foreseen to remain broadly stable at about 1% of world GDP up to
2018. The different trends experienced by the part of deficit and surplus countries have
been determining a progressive imbalance of the European Union as a whole to a stance
of net creditor to the rest of the world, though in presence of persisting discrepancies at
the level of individual member countries.
Japan and the group of developing and newly industrialized East Asian countries have
followed a very similar pattern of adjustment. Their surpluses have contracted in the
immediate aftermath of the financial crisis, have then recovered to pre-crisis levels in
2009-2010, and finally contracted again. In 2006, surplus run by Japan and East Asian
countries both accounted for 0.3% of world GDP – equal to 3.9% and 5.7% of GDP
respectively. In 2012, these figures decreased to 0.1% and 0.2% of world GDP – 1.0% and
3.9% of the respective GDP. The IMF estimates foresee that such levels would be broadly
maintained in the period 2013-2018.
China has suffered a strong contraction in current account imbalances after the global
crisis. China’s surplus has increased from $232 billion in 2006 to $421 billion in 2008, to
sharply contract to $136 billion in 2001 and slightly recover to $193 billion in 2012.
Relative to the country’s GDP, the surplus in current account balances shifted from 8.6%
in 2006 to 10.1% in 2007, to 1.9% in 2011 and 2.4% in 2012. The IMF foresees a gradually
recover of the surplus up to reach a value equal to about 4% of GDP in 2018, a level that
would represent 0.6% of world GDP, a level equal to the position observed in 2007.
The surplus run by oil exporters as a group has been heavily contracting as well in the
aftermath of the crisis, shifting from 1.0% of world GDP in 2006 and 2008 to 0.3% in
2009. Relative to the group’s aggregate GDP, this decrease has been from 16.5% in 2006
to 4.4% in 2009. The oil exporters’ surplus then recovered in 2011 and 2012 to a level
similar to the pre-crisis level both relative to world GDP and the group’s GDP. However,
based on the IMF estimates, it is expected to decrease in the period 2013-2018, to reach
a level equal to about 3% of the group’s GDP and 0.3% of world GDP.
Interestingly, the group representing the rest of the world, which in 2006 accounted for
an absolutely negligible part of the overall picture, in the aftermath of the crisis has been
69
characterized by a progressive increase in the size of its aggregate deficit. Figure 35 clearly shows
that the dynamics followed by the deficit run by the “rest of the world” group has been specular
to that of the US. Thus, in a number of countries other than those considered so far the role of
external funding in financing domestic investment is increased over time, and those countries have
thereby partially substituted the US and the deficit countries of Europe in absorbing the surplus
generated by China, Japan, East Asian countries, the oil exporters and the surplus countries of
Europe. What are these countries? Figure 36 shows the first ten countries belonging to the “rest
of the world” group ordered for the size of their balance of payments deficit in 2012. India enlarged
its external deficit from 1.0% of in 2006 GDP to 4.8% in 2012. Canada and Brazil shifted from a net
surplus position in 2006 – respectively, 1.4% and 1.3% of GDP – to a deficit position in 2012 – equal
to 3.4% and 2.4% of GDP respectively. Australia and Turkey maintained a similar level of external
deficit between 2006 and 2012. Also South Africa ran in 2012 a sizeable deficit, equal to 6.3 of
GDP. The IMF previsions for 2018 see an enlargement of the deficit position for Turkey and Brazil,
and a relative contraction for India, Canada, Australia and South Africa. Should these patterns be
regarded as possible warning signals for future financial troubles in those countries?
Figure 36. New deficit countries (current account balance, ratio to world GDP)
Source: elaboration on IMF World Economic Outlook (October 2013) data
4.2.2 Global imbalances and financial risk: evidences from the crisis
The great number of data made available by the outcomes of the crisis may allow for the possibility
to formulate a more thorough evaluation of the connections between current account imbalances,
financial turmoil and economic crises. In particular, it would be useful to assess the extent to which
the current account adjustment and/or the reduction in the output following the crisis were
sharper in countries where pre-crisis imbalances were more evident. Significant evidences in this
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70
regard would support the idea of a link between global imbalances and financial risk, or at least
the possibility of inferring the event of a shift toward more hazardous financial environments from
data on current account imbalances. This is the focus of a paper by Lane and Milesi-Ferretti (2011),
which note how “the large compression in the distribution of current account balances between
the pre-crisis period and 2010 provides a laboratory for studying the economics of external
adjustment”.102
In this contribution, data about global imbalances referred to 65 advanced economies
and emerging markets and covering the period 1968-2008 are regressed against a matrix of
economic, demographic and financial variables. With reference to the recent global crisis, the
results of this analysis do actually confirm that countries whose current account balances were in
excess of what could be explained by standard economic fundamentals prior to the crisis also
experienced the largest contractions in their external balance during the adjustment period. As a
conclusion, the distribution of current account gaps at the onset of the crisis is confirmed to be “a
good predictor of the distribution of macroeconomic outcome” during the subsequent adjustment
phase.103 In addition, is highlighted how the analysis results also suggest a much stronger link
between pre-crisis current account gaps – namely deviations of observed current account balances
from levels consistent with macroeconomic fundamentals – and subsequent current account
changes for countries that prior to the crisis had negative current account gaps, a finding which is
considered to be consistent with the notion that during a crisis the adjustment burden falls
primarily on deficit countries.
A second issue addressed by Lane and Milesi-Ferretti (2011) is the examination of how
external adjustment has taken place. Considering deficit countries, two main possibilities are
described. The first is represented by the so-called expenditure-switching channel of adjustment,
where deficit contractions are driven by movements in exchange rates that generate changes in
the relative prices of goods across countries. The second adjustment channel is represented by
domestic expenditure reduction. Prior to the crisis, the idea that movements in exchange rates
would have eventually acted to correct external imbalances was generally recognized. In this
perspective, strong currency depreciations by the side of deficit countries would have allowed for
shifts in national expenditure fostering domestic production and reducing the degree of
dependence on export from abroad. In this regard, Obstfeld and Rogoff (2007) showed that the
effectiveness of the expenditure-switching channel depends mainly on the flexibility and global
integration of goods and factor markets and estimated that for the US current account deficit to
shrink from 5% of GDP to zero, it would have required a large depreciation of the US dollar
(between 20% and 40%).104 A survey conducted by the economist associated with Bruegel, the
Peterson Institute and KIEP conclude that “a real effective depreciation of the dollar between 10
102 Lane and Milesi-Ferretti (2011), p. 18. 103 Ibid., p. 14. 104 Obstfeld and Rogoff (2007), p. 362.
71
and 20 per cent from the current level [March 2007]” would have led “the US current account
deficit to [shrink to] 3 per cent of GDP over the next few years”.105
The outbreak of the crisis has refuted these forecasts. Adjustment in deficit countries
actually took place primarily through the second adjustment channel – that is, through steep
declines in domestic output and demand relative to the pre-crisis period – rather than through
changes in exchange rates. Indeed, as underlined in Lane and Milesi-Ferretti (2011), the exchange
rate adjustment played a very modest role in the overall external adjustment process. In this
regard, it is underlined that high output costs having been associated with rapidly correcting large
current account imbalances in the aftermath of the crisis “provide additional empirical support for
research that assesses whether current account deficits during good times might partly reflect
distortions that fail to internalize the risk of a subsequent sudden stop”.106 The case of the United
States is particularly striking. After an initial depreciation – between March 2007 and March 2008
the dollar lose 10% of its value – between March 2008 and March 2009 the US dollar actually
strongly appreciated by 20%, due to capital inflows to the US to invest in the “safe haven” of
government treasuries (for a deeper insight on this issue please refer to the next paragraph).
Thus the expected strong depreciation of the US dollar has not occurred. In this regard,
some lines of research underline that, even if the dollar had actually depreciated, this would have
produced much more limited results that what expected. A research by Wei Dong (2010) highlights
that the responsiveness of both US exports and imports to exchange rate movements had declined
in recent years, mainly due to changes in firms’ pricing behaviour and larger distribution
margins.107 Starting from the early 1990s, US exports’ responsiveness to exchange rate movements
was found to be 18% less than in the previous two decades, and US imports’ responsiveness to
exchange rate movements to be nearly zero. This suggests that closing the US trade deficit through
exchange rate movements would have required far larger movement in exchange rates relative to
what required in the 1970s and 1980s. A recent empirical analysis by Allegret and Sallenave (2014)
also concludes that “dollar adjustment does not seem to be able to play a major role in global
rebalancing” and that – generally speaking – “if exchange rate adjustment matters to reduce global
imbalances […] we must not wait too much about the magnitude of this influence”.108 Thus, it can
be concluded that both a decreased elasticity of trade flows to exchange rate movements and the
international role of dollar-denominated safe securities – which actually supported the value of
the dollar impeding its expected depreciation – have caused almost the entire size of external
adjustment in the US to be achieved through the painful channel of output reduction.
Another significant issue addressed by Lane and Milesi-Ferretti (2011) is the extent to
which the correction in current account balances which has been observed in the years following
105 Ahearne et al. (2007), pp. 5-6. 106 Lane and Milesi-Ferretti (2011), p. 18. 107 Wei Dong (2010), p. 18. 108 Allegret and Sallenave (2014), p. 158.
72
the crisis will be persistent. With reference to deficit countries, it is noted how the crisis has led to
a significant downward revision in potential output in several countries, suggesting that pre-crisis
imbalances may have reflected overheating at least to some extent. Two possible major scenarios
are traced. Given that current account corrections in deficit countries were mainly due to
phenomena of undershooting of output and demand, one first output refers to the possibility that
the decline in excess deficits could prove to be temporary – at least in part – unless exchange rate
movements allow for more meaningful expenditure switching. Another possibility is that countries
with high external liabilities may face persistent external financing constraints. In this second case,
if price and exchange rate rigidities prevent effective expenditure switching, output may remain
below potential for an extended period of time.109
4.3 The US exorbitant duty
4.3.1 Adverse valuation effects in time of crisis
In the previous chapter, the existence of an enduring exorbitant privilege enjoyed by the United
States has been discussed. The exorbitant privilege manifested itself in the ability by the part of
the United States to exploit significantly positive valuation effects on its external asset and liability
stocks – and as a consequence, to earn a higher return on its external assets than what offered to
foreign investors on its external liabilities. This excess return can be divided into two main
components: a composition effect resulting from an asymmetric structure of the US external
balance sheet – assets are riskier and less liquid than liabilities – and a return effect resulting from
an excess return within class of assets.110 It’s worth briefly recalling that one major consequence
of the exorbitant privilege is to relax the external constraint of the US, allowing it to run larger
trade and current account deficits without commensurately worsening its external position. The
analysis of data relative to the post-crisis period can add further empirical evidences and allow the
attainment of a deeper understanding of the whole phenomenon.
Figure 37 reports a focus on the dynamics of the net international investment position
over the period 2006-2013. For a comparison, the Figure reports also the pattern that can be
obtained simply cumulating – starting from the ending position of 2005 – the series of quarterly
current account deficits. After having been continuously improving since 2001, the NIIP has
experienced a strong plunge between the third quarter of 2007 and the fourth quarter of 2008.
Over this period, the NIIP has fallen from -10.8% of GDP to -22.4% of GDP. The overall negative
change – a drop equal to about one tenth of US GDP – has been equally divided between changes
due to deficits in the current account balance (summing up to 5.7% of GDP over the period) and
changes due to unfavourable valuation effects (summing up to 5.0% of GDP). Changes in the NIIP
due to valuation effects have been highlighted in Figure 37. It can be noted how valuation effects
109 Lane and Milesi-Ferretti (2011), p. 18. 110 Gourinchas and Rey (2007), pp. 12-13.
73
have negatively contributed the dynamics of the NIIP – thus determining a further downturn in
addition to that due to a negative current account balance – in the first, third and fourth quarters
of 2008, and later in 2011 (in particular in correspondence of the third quarter) and to a lesser
extent in 2012 (second quarter) and 2013 (first and second quarter).
Figure 37. Cumulated current account and NIIP, 2006-2013III
Source: elaboration on Bureau of Economic Analysis data
Adjustments in valuation suggest that – over such periods – the price of US holdings
abroad has been contracting more than that of foreign holdings in the US. This last development
indicates a reversal of the usual US exorbitant privilege – implying a wealth transfer from the rest
of the world to the US – in that, during a crisis, wealth flows instead from the US to the rest of the
world.111 Gourinchas, Rey, and Govillot (2010) call this phenomenon the exorbitant duty of the US:
in times of global stress, the US effectively provides insurance to the rest of the world. Exorbitant
privilege and exorbitant privilege can thus be viewed as the two sides of the same coin. Their
specular effect reflects the structure of payments associated with an implicit insurance contract
between the US and the rest of the world.
Indeed, the observation of the existence of an exorbitant duty suffered by the US in times
of crisis is to be related to the specific structure of the US external position which – as already
discussed in the previous chapter – is short in safe and liquid securities and long in risky and illiquid
ones. As shown in Figure 38, between July 2007 and March 2009, the S&P 500 stock price index
has lost one half of its value. On the contrary, the value of US bonds has remained broadly stable.
In particular, the valuation of US Treasury bills and bonds did not collapse during the crisis, as
111 Gourinchas, Rey, and Govillot (2010), p. 1.
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Change in NIIP due to valuation effects (secondary axis) Cumulated CA NIIP
74
shown in Figure 39, which reports the dynamics of a proxy of US Treasuries – the Northern US
Treasury Index (BTIAX). US Treasuries held-up remarkably well and even saw their price rise due
to the crisis, due to inflows of capital seeking safe haven protection.112
Figure 38. US stock price index, 1980-January 2014
Source: elaboration on Federal Reserve Economic Data
Figure 39. US treasury securities index, 1996-February 2014
Source: elaboration on finance market indicators
Figure 40. Composition of US external assets (ratio to GDP), 2006-2013III
112 Gourinchas, Rey and Trempler (2012), p. 279.
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75
Source: elaboration on Bureau of Economic Analysis data
Figure 41. Composition of US external liabilities (ratio to GDP), 2006-2013III
Source: elaboration on Bureau of Economic Analysis data
These trends have reflected themselves on the dynamics of the components of US
external assets and liabilities, which are reported in Figures 40 and 41. The value of equity assets
has lost a value equal to 19% of GDP, plummeting from 36% of GDP in the third quarter of 2007 to
17% of GDP in the first quarter of 2009. To a lesser extent a similar picture emerges also for bank
loans and debt held as external assets, which over 2008 have lost a value equal respectively to
3.6% and 2.5% of GDP. On the contrary, US debt liabilities increased during the whole considered
period, from 35% of GDP in the first quarter of 2006 to 56% of GDP in the first quarter of 2013.
There was only a small decrease over the first three quarters of 2008 due to the collapse of Lehman
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Brothers. Also US equity liability lost value during the crisis, dropping from 20.1% to 11.5% of GDP
between the third quarter of 2007 and the first quarter of 2009. However, in this regard it’s worth
stressing again the relative weight of equities on the total consistence of US assets (30.4% in
2007:4 and 20.1% in 2009:3) relative to the same figures for liabilities (15.4% and 10.8%).
4.3.2 The United States as a global insurer
It can be concluded that – in times of crisis – the value of US risky external financial portfolio
collapses relative to the value of safe external liabilities. Together with the appreciation of the
dollar, the relative stability in the value of US bonds has led to a massive wealth transfer of the US
towards the rest of the world. As in Gourinchas, Rey and Govillot (2010), the contrast of safe
external liabilities versus risky external assets is at the heart of the interpretation of the role of the
United States in the centre of the international monetary system. This role can be interpreted as
that of a global insurer. Indeed, when the global crisis hit, the US has provided insurance to the
world – the US exorbitant duty.113 If the US provides insurance against global shocks, it follows
than the rest of the world should pay and insurance premium to the US in normal times – the US
exorbitant privilege. As underlined by Gourinchas, Rey and Truempler (2012), in normal times the
rest of the world must display – in the aggregate – a pattern of external position opposite to that
of the US: long in safe and liquid assets and short in risky and illiquid ones. As a consequence, it
must earn a lower return on its external claims than it pays on its external liabilities. In times of
crisis, however, the valuation loss of the US represents a valuation gain for the rest of the world.
Gourinchas, Rey and Truempler (2012) underline that from this reasoning, it cannot be
concluded that all countries benefit equally from their exposure to the US. The simple proposition
that all countries benefited from the US valuation losses is not supported by the data. This is due
to the fact that different countries or regions investing their savings in the US may choose a
different position on the risk-return frontier offered by the number of US financial assets. For
instance, the fact that the crisis – even if originated in the subprime segment of the US housing
and financial market – has had such a tremendous impact on the economy of the European Union
has been largely due to heavy losses numerous European financial institutions suffered on their
holdings of US mortgage-backed securities. On the contrary, many emerging market countries
chose to concentrate their holdings of external financial claims in the form of US government
securities – US Treasury bills and bonds – which provided what has been defined a safe haven in
the midst of the crisis.114
In this regard Gourinchas, Rey and Truempler (2012) stress the fact that, even if it’s true
that most countries were badly hit by the crisis and their total financial wealth declined massively,
at the same time external valuation gains and losses differed greatly across countries, so that
relative losers and relative gainers can be identified. The Euro Area, China and Switzerland all
113 Gourinchas, Rey and Govillot (2010), p. 9. 114 Gourinchas, Rey and Truempler (2012), p. 267.
77
experienced sizeable losses, while the UK, Russia, Brazil and emerging Asia were the main net
beneficiaries. Such capital gains and losses are found to be not negligible, even when compared
to total wealth losses.115 Countries long equity or direct investment faced losses on their net
positions, as risky assets took some of the sharpest valuation falls in the crisis. For portfolio debt,
the exact structure of the external debt portfolio – in particular whether debt assets are mostly
government or corporate bonds or asset backed mortgage securities – is a crucial determinant of
the valuation gains and losses. Countries who self-insured by holding mostly US government bonds
tended to limit losses on their net debt portfolios, while countries who levered heavily to invest in
risky asset backed mortgage securities or other toxic assets experienced greater losses on their
net debt. The case of China is brought as an example. China suffered a loss on its foreign non-
dollar exchange reserve holdings due to the fact that most currencies lost ground against the US
dollar. However, capital gains on US bonds more than offset the exchange rate losses on sterling
and euro assets. Therefore, the decline in China’s net external wealth would have been much more
pronounced were it not for its large holdings of US government securities.116
The United States – the country at the centre of the international monetary system and
issuer of the main reserve assets – provided most of the insurance during the crisis, as its
international investment position deteriorated massively. However, the US is found not to be the
only country experiencing valuation losses during the crisis. The EU area, Switzerland and –
although at a lesser extent – China are found to have followed a similar pattern of wealth transfer
to the rest of the world. These countries can be regarded like regional insurers. Gourinchas, Rey
and Truempler (2012) conclude that it’s incorrect to think to the US as the single provider of global
liquidity. On the contrary, these findings suggest that – with respect to global liquidity provision –
the global economy may have already moved toward a multilateral system.117
4.3.3 Exorbitant privilege and exorbitant duty compared
As discussed above, exorbitant privilege and exorbitant duty can be viewed as two sides of the
same coin. Which has prevailed over the past years? Have the wealth transfer from the US to the
rest of the world which happened during the crisis years been so wide to be capable of repaying
the opposite wealth transfer – from the rest of the world to the US – which took place in “good
times”? Figure 42 compares the breadth of exorbitant privilege and exorbitant duty. It shows the
changes in the US net international investment position which can be attributed to valuation
effects – in terms of difference between the annual current account deficit and the change in the
NIIP occurred in that same year – as a ratio of GDP. As discussed before, in recent times the
phenomenon of exorbitant duty manifested itself mainly in 2008 and 2011 (with a size of 5.1% and
6.0% of GDP respectively). To a lesser extent, it showed up also in 1981, 1984, 1991, 1992, 1997,
2000 and 2001. In all remaining years the US enjoyed the exorbitant privilege of capital gains on
115 Gourinchas, Rey and Truempler (2012), p. 281. 116 Ibid., p. 272-273. 117 Ibid., p. 273.
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its external position, with maximum levels observed in 2005 (9.2% of GDP), 2007 (8.3%) and 2009
(9.0%), and levels equal or higher than 5% of GDP observed also in 1999, 2003, 2004 and 2006.
Figure 42. Exorbitant privilege and exorbitant duty, 1980-2012
Source: elaboration on Bureau of Economic Analysis data
Interestingly, in 2009 and 2010 the US enjoyed a level of “privilege” similar to that which
characterized the pre-crisis years. This can be related to the phenomenon for which, as the crisis
spread worldwide, the US – though being the epicentre of the financial crisis – represented a “safe
haven” for international investors (as discussed before, this feature manifested itself also in the
strong appreciation of the dollar in 2009). This in turn allowed the US to continue enjoying capital
gains on its external position, even in time of global recession. Over the whole considered period,
exorbitant privilege stood at exorbitant duty at a ratio of 3.5 to 1. This ratio rose to 4.6 to 1 in the
decade 2002-2012. From this can be concluded that, if it’s true that the US has to suffer the burden
of consistent wealth transfers to the rest of the world during times of crisis, it’s as well true that
this duty is not so “exorbitant” as the privilege enjoyed during “good times” in terms of wealth
transfers from the rest of the world to the US. Therefore, it could be stated that, over the last two
decades, to the “US exorbitant privilege” rather corresponded a “US moderate duty”.
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Changes in theNIIP due tovaluation effects
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Chapter 5. China’s contribution to global imbalances
5.1 Drivers of the Chinese savings’ dynamics
5.1.1 Overview of China’s current account imbalances
From the previous chapters it clearly emerged how China has played a role of major importance
as regard the emergence and widening of imbalanced patterns of international capital flows,
which in turn strongly contributed in sowing the seeds for the global financial and economic crisis.
Starting from the end of the 1990s, China has been continuously running current account
surpluses. The size of the Chinese external surplus has surged from 1.3% of GDP in 2001 to 10.1%
of GDP in 2007, to substantially narrow since the global financial crisis and eventually reaching a
level equal to 1.9% of GDP in 2011 and 2.3% of GDP in 2012. Which are the causes of this persisting
surplus? As shown in Figure 43, investment rose from 35.1% of GDP in 2000 to 48.9% in 2012, thus
weak investment can’t lie behind the dynamics of current account surpluses. On the contrary, the
main driver of the Chinese current account surplus can be found in the dynamics of domestic
savings, and this is true both in the pre-crisis decade and after the crisis. In the period 2000-2008
Chinese savings have been capable to grow even faster than the booming trend of national
investment. Stating from a level equal to 35.1% of GDP in 2000, they surged to the staggering level
of 53.4% in 2008, with an average growth pace of 5.4% a year. After the crisis, China’s domestic
savings have inverted their trend – decreasing to 51.2% of GDP in 2012 – in the presence of a still
growing trend of investment, causing a strong shrinkage in the current account balance.
Figure 43. Savings, investment and CA balance in China (ratio to GDP), 1980-2012
Source: elaboration on IMF World Economic Outlook (October 2013) data
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Understanding the causes which led to this uncommonly high level of domestic savings
and current balance surpluses is of major importance in order to reach a deeper understanding of
China’s economic development as well as world imbalances. In this regard, the role of the Chinese
government’s intervention in exchange markets to maintain an undervalued peg between the
renminbi and the US dollar is often identified as the most prominent cause of China’s imbalances.
In general, a government can maintain the peg by buying or selling foreign reserves to oppose
market changes in the demand and supply of the domestic currency. In order to counteract the
risen demand for renminbi for trade and investment purposes – that would, in a free market
system, have determined an upward trend in its value – the Chinese government has been buying
foreign exchange, mainly in the form of dollars, in exchange of domestic currency. In this
perspective, the undervalued renminbi would have strongly distorted the Chinese terms of trade,
subsidized exports and determined the rising level of current account surplus in the 2000s. It’s
worth deepening this argument.
5.1.2 The contribution of the exchange rate dynamics
Figure 44 reports the dynamics of nominal and real effective exchange rates, which are indexes
that describe the relative strength of a currency relative to a basket of foreign currencies. The Bank
for International Settlements computes the nominal effective exchange rate (NEER) as a geometric
weighted average of bilateral exchange rates, and the real effective exchange rate (REER) as the
same weighted average of bilateral exchange rates adjusted by relative consumer prices. In both
cases, an upward movement represents an appreciation of the currency. The dynamics of effective
exchange rates can help explain the movements in the Chinese current account balance. Over the
past twenty years the nominal and real effective exchange rates of the renminbi appreciated by
55% and 81% respectively. What matter more with regard to the emergence or absorption of
external imbalances is the real effective exchange rate in that it represents a trade-weighted and
inflation-adjusted index of terms of trade. Movements in the real effective exchange rate can be
explained with the combination of movements in the nominal effective exchange rate and
price/wage inflation differentials (in Figure 44 the consumer price index is considered as a proxy
of the latter).118
After the Asian crisis, the renminbi’s REER went through two distinct phases: the
currency depreciated during the first period (from 1998 to 2005) and appreciated during the
second one (since 2005). During the first period, being the renminbi pegged the US dollar, the
renminbi’s NEER followed the dynamics of the dollar’s NEER. After the dollar peaked in early 2002,
the renminbi’s NEER thus fell with the dollar’s NEER to end 15% lower in 2004. At the same time,
the deflationary force determined by depreciations of neighbouring currencies – a major
consequence of the Asian crisis – together with the effects of the domestic corporate restructuring
118 Ma, McCauley, and Lam (2013), pp. 79-81.
81
led to a persistent dynamics of price stagnation in China.119 Therefore, due both to the NEER
depreciation and to relative disinflation, in the period 1998-2005 the real effective exchange rate
depreciated by 19% (-2.9% per annum). This real depreciation, in enhancing Chinese external
competitiveness, is highly likely to have contributed to the expansion of the current account
surpluses which took place in the first half of the 2000s.
Figure 44. Renminbi’s REER, NEER, and CPI (index, 2010 = 100), 1994-December 2013
Source: elaboration on Bank for International Settlements data
Figure 45. Nominal exchange rate of the renminbi to the US dollar, 1981-February 2014
119 Ma, McCauley and Lam (2013).
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Chinese Yuan to oneUS Dollar
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Source: elaboration on Federal Reserve Economic Data
Most of the overall currency appreciation observed since mid-nineties took place during
the second period, after the decision – took in July 2005 – to break the peg of the renminbi toward
the US dollar and anchor the national currency to a basket of international currencies, introducing
a regime of managed floating exchange. The main reasons that led to this decision were the need
to keep an eye on potential inflation, US political pressure and a desire to upgrade the economy
toward a more domestic-oriented growth model.120 Figure 45 shows the nominal exchange rate
of the Chinese Yuan to one US Dollar (in this case, an upward movement of the exchange rate
represents a depreciation of the renminbi). Since 2005 the nominal exchange rate of the renminbi
to the US dollar gradually appreciated. In the first month of 2014 one US dollar was sold for 6.1
yuan, while it was sold for 8.3 yuan between mid-1995 and mid-2005 – thus totalling a 37%
appreciation in almost nine years. This result, however, needs to be seen in context. These were
indeed years of currency volatility and many of China’s trade competitors saw their currency fall
sharply against the dollar. As a consequence, it’s likely that in pricing goods for the US market
China was disadvantaged to an even greater extent.121
At the same time, inflation began to grow again (as shown in the dynamics of the CPI
reported in Figure 44). The NEER and inflation thus worked together to appreciate the real
effective exchange rate, which between the beginning of 2005 and the end of 2013 increased by
43% (with an average pace of 4.1% per annum). Estimates of the dynamics of the REER based on
unit labour costs rather than consumer prices have been carried out by Ma, McCauley and Lam
(2013) and suggest an ever higher rate of real appreciation (between 7% and 8% per annum since
2005) with significantly sizeable increases in China’s manufacturing labour cost observed in 2010
and 2011. An appreciation of the REER represents a signal of profit for investment in the non-
traded goods sector: it makes exports less competitive and imports more attractive and as a
consequence helps to shift production from export to home goods and services. The renminbi real
appreciation occurred since the mid-2000s is thus likely to have contributed to the sizable
shrinkage of Chinese current account surpluses from the pre-crisis peak. Therefore, exchange rate
movements appear to be consistent with the movements of pre-crisis expansion and subsequent
adjustment of the Chinese current account balance.122
In contrast to this view, it has been argued that a revaluation of the renminbi would not
alone significantly affect China’s current account balance due a likely decrease in imports from
Southeast Asian countries that would accompany a decrease in exports to the western countries.
Less demand for finished goods from China would indeed cause China to import fewer
intermediate goods and raw materials.123 Moreover, one could note that in order to keep its
120 Beardson (2013), pp. 118-119. 121 Ibid., p. 119. 122 Ma and McCauley (2013), p. 8. 123 Garcia-Herrero and Koivu (2007), p. 27.
83
currency persistently undervalued, China would have to cope with strong inflationary pressures.
Though inflation has been relatively high in recent times, its level does not appear to reflect a
strong degree of undervaluation of the renminbi.124 Econometric analysis carried out by Cheung,
Chinn, and Fuji (2009) and Dunaway, Leigh, and Li (2006) confirm that the hypothesis of excessive
artificial undervaluation of the renminbi generally lacks of robustness. Therefore, the idea that
currency manipulation entirely explains Chinese imbalances is not convincing. If it’s likely that the
dynamics of exchange rates have contributed to the emergence and widening of the Chinese
current account surpluses in the pre-crisis years, it’s likely as well that other factors have played a
far major role. In this regard, it’s important to underline that all explanations of the Chinese saving
behaviour are in many ways interrelated, and are certainly not mutually exclusive. On the contrary,
all contribute to a varying extent to outline the whole picture.
Which are the causes of the extraordinary surge in savings which occurred over the
2000s? According to Ma, McCauley, and Lam (2013) the answer is to find in large income windfalls
from productivity and demand shocks that have been saved. These positive shocks derive either
from secular economic and demographic trends and forces and key institutional changes.125 Four
major sets of shocks can be identified. The first one is related to the interaction between
demographic dividends and the rural-urban labour migration which took place over the nineties
and 2000s. The second set encompasses efficiency gains from restructuring and labour shedding
in state-owned enterprises over the nineties. The third set involves important institutional changes
within China during the nineties and 2000s, in particular the transition to a new pension system
and the introduction of private home ownership. The fourth set relates to positive productivity
shocks from China’s WTO accession in 2001. All these sets of shocks together boosted supply
relative to demand and stimulated investment more than consumption. It’s worth considering and
discussing them one by one.
5.1.3 Demographic transition and reforms in agriculture and industry
China’s demographic transition started in mid-1970s and was by that time very compressed. The
ratio of working-age to total population rose rapidly, from 56% in 1975 to 73% in 2007, a level
unchanged through 2012. Consequently China’s dependency ratio – the ratio of dependents
(people younger than 15 or older than 64) to the working-age population – dropped from the level
of about 80% prevailing up to mid-seventies to a level of about 55% in the early nineties and, after
some years of stagnation over the nineties, again to 36% at the end of the 2000s and up to 2012
(see Figure 46). The labour supply has been therefore supercharged, particularly over the 1980s
and the 2000s.
This strong demographic transition was combined with a series of key reforms
introduced in the late 1970s and early 1980s at the hands of Paramount Leader Deng Xiaoping,
124 Trachtman (2011). 125 Ma and Yi (2010), p. 7.
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Premier Zhao Ziyang and Secretary General of the Party Hu Yaobang. The approach adopted by
Deng consisted in moving ahead with economic reforms slowly and pragmatically, encouraging
various local experiments and then extending elsewhere whatever found to be successful. The
ancient Chinese proverb of “crossing the river touching the stone” – to be intended as an image
of the reformer who carefully searches the right direction step-by-step – is often used to describe
this trial-and-error approach to reform.126 Another ancient Chinese motto, “searching truth from
facts”, was resumed by Deng as the guiding philosophy for China’s reform and opening up. Deng
believed that facts rather than ideological dogmas, whether from the East or West, should serve
as the ultimate criteria for assessing the correctness of a policy. Zhang Weiwei (2011) underlines
that this idea is in line with the concept of reason during the Enlightenment of Europe, “as both
ideas broke away from the rigid ideological straitjacket of the past and emphasized human
capacity for reasoning and ushered in the respective industrial revolution”.127 Beardson (2013)
effectively synthetize the way in which reforms were – and currently are – commonly introduced
in China:
“Generally, reform is discussed within the Party at one speed, is pursued more slowly,
and is announced even more slowly. Many of China's reforms started with local action. They
benefited from a combination of central benevolence and passivity until their success was evident,
at which point the leadership decided the bus was going in the right direction and the seats were
comfortable.” 128
Figure 46. Ratio of working-age on total population and age dependency ratio in China, 1960-2012
126 Zhang Weiwei (2011), p. 97. 127 Ibid., p. 125. 128 Beardson (2103), p. 51.
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Source: elaboration on World Bank data
The agricultural reforms consisted in a phased dismantling of the Maoist commune
system – by which the land of the communes was divided into individual plots – and in the gradual
introduction of the so-called “household responsibility system”, by which the local farmers were
held individually responsible for the production of their farm. To these was added in 1984 a
significant industrial reform – the "Decision of the Central Committee of the Chinese Communist
Party on Reform of the Economic Structure" – by which market mechanisms were firstly
introduced in the industry sector. The agriculture and industry reforms led to two main outcomes:
more efficient agriculture released surplus labour, and this in turn encouraged the creation of the
network of town and village enterprises (TVEs) which brought commercial activity into the
countryside and drove economic growth in the 1980s. Even not formally private, the TVEs
constituted the seedbeds for private enterprise. It has been estimated that by the end of the 1990s
more than half of TVEs in many large provinces had been privatized.129 As shown in Figure 47, the
percentage of total employment occupied in agriculture has been falling by half over the past three
decades, from a level of almost 70% in 1980 to 35% in 2011. Conversely, the share of employment
in industry has risen from 18% to 30% and that of services from 13% to 35%. At the same time, the
agricultural sector’s share in GDP has fallen from 30% in 1980 to 10% in 2008.130 The agricultural
and industry reforms allowed the huge potential for development guaranteed by the demographic
dividend to fully unfold.
Figure 47. Employment in agriculture, industry and services (% on total employment), 1980-2011
129 Beardson (2103), p. 55. 130 Ma and Yi (2010), p. 7.
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Source: elaboration on World Bank data
Figure 48. Urban population (percentage of total population) in China, 1960-2012
Source: elaboration on World Bank data
The dynamics of urban population as a share of total population is reported in Figure 48.
Urban population averaged 18% over the 1960s and 1970s. Between 1980 and 2012 it has been
increasing at a steady pace of 3.1% per annum. Urban population overtook 50% of Chinese
population in 2011 and reached 51.8% in 2012. These figures synthetize a tremendous
phenomenon of rural-urban migration of workers from the countryside to the cities, large part of
which has consisted in migration from the internal provinces of China to the urban metropolis of
the Pacific coast – and particularly to Shanghai and the Guangdong. This phenomenon has been
massive in size and increasing over time. It consisted of flows of 7 million people per annum on
average over the 1980s, 11 million people per annum over the 1990s, and 17 million people per
annum over the 2000s, for a gross total of more than 400 million people between the late 1970s
and 2012. This persistent flow of labour force from the farms to the new factories can surely be
considered one of the major sources of the Chinese current account surpluses as well as of global
imbalances, in that it has represented over the last three decades the true engine and real driving
force of the overall process of industrialization and capitalistic development by which the
emergence of the former has been made possible.
An important consequence of this process was that industry and services drew surplus
labour from the agricultural sector at a low wage rate – given the persisting high level of labour
supply, an “industrial reserve army” in Marxist terminology – and this in turn determined a falling
labour share and a rising profit share in income. In other words, growing employment did not push
up wages and most of the benefit of productivity growth went away from wages and towards
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profits.131 High returns to capital in turn stimulated investment, accelerated capital accumulation
and fostered economic growth during the transformation phase. An important contribution to the
supply of abundant cheap labour went – and still come nowadays – from China’s Hukou
(household registration) system which refuses to migrant workers from the countryside the
possibility to be eligible for benefits or labour protections, in a way to institutionalize migrant
workers to be paid far below marginal product.132
Figure 49. Labour income share in China, 1992-2008
Note: The sudden change between 2003 and 2004 likely reflects an adjustment to the data.
Source: elaboration on ILO data
Data from the International Labour Organization on the wage share of income133 confirm
this approach. Figure 49 shows how the wage share in income fell from about 65% in the early
1990s to almost 50% at the end of the 2000s. Data from the International Monetary Fund134
describe a similar pattern, with Chinese labour share of income falling from 54% in 2002 to 48% in
2008. Ma and McCauley (2013) underline that these labour market developments have had
important effects for external competitiveness as well as for internal balance and, in particular,
for the structure of domestic absorption. One the one hand, a stagnant or decreasing level of unit
labour costs tends to strengthen the competitiveness of manufactured exports, this in turn raising
profits and enabling a higher level of corporate savings. On the other hand, a fall in the labour
share of income tends to restrain private consumption and to boost the domestic saving rate,
131 Ma and McCauley (2013), p. 6. 132 Tratchman (2011). 133 Source: ILO calculations based on data from the China Statistical Yearbooks, reported in the ILO Global Wage Report 2012/13. The ILO calculates the unadjusted wage share as total labour compensation of employees divided by value added. 134 Reported in Ma and McCauley (2013), p. 7.
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therefore for a given level of domestic capital formation, the current account surplus tends to
widen.135
5.1.4 Major institutional reforms
A number of major institutional reforms introduced since the 1990s are highly likely to have
influenced the Chinese saving trends. First, starting from the mid-nineties, China went through a
though process of corporate restructuring which involved, in particular, the network of state-
owned enterprises. As in Ma, McCauley and Lam (2013), “loss-making state enterprises, which had
proved cradle-to-grave social welfare and job security to employees, were shut down, sold or
merged” and as a result “employment at state companies fell by almost half during 1995-2005”.
The process of corporate restructuring “led to fewer, leaner, and more profitable state companies
and made room for more efficient indigenous private firms”. This process not only boosted
corporate savings by ensuring a higher level of profits, but boosted precautionary household
savings as well due to greater job insecurity and expenditure uncertainty imposed to workers. 136
Figure 50. China’s population pyramid, 2013 (million people on horizontal axis)
Source: elaboration on US Census Bureau – International Data Base
135 Ma and McCauley (2013), p. 6. 136 Ma, McCauley and Lam (2013), p. 75.
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Second, important fiscal and property right changes within China took place in China over
the 1990s and 2000s. In 1997 China adopted a new pension system which transformed the
previous pay-as-you-go system to an ill-defined three-pillar system that often reduced pension
benefits and increased contributions, whereby spurring both household and government savings.
At the same time, concern was raised in China on the expectation of a fast-aging population. In
this regard, Figure 50 reports the population pyramid for China in 2013, from which it does emerge
that, between ten and fifteen years, the large cohorts born in the sixties will reach the retirement
age and will be replaced by the far narrower cohorts born in the late nineties and 2000s. Ma and
Yi (2010) argue that the outcome of reduced pension wealth brought about by the pension reform
interacted with the rising pressure on public retirement schemes due to the anticipated
acceleration of population ageing, inducing an additional accumulation of precautionary
savings.137
Alongside with the pension reform, private home ownership and property market
became possible for the first time in the People’s Republic during the nineties, boosting incentives
to save by households in order to build up private assets in anticipation of retirement. It is
documented that China’s physical assets of residential housing per capita have roughly doubled
over the 1990s and 2000s and that, over the same period, the fastest-growing sectors in the
Chinese economy have been the construction and services and not the manufacturing sector.138
The private property ownership reform thus set the stage for the expansion of a deep real estate
investment boom over the 2000s (concurrently with the multiple housing speculative bubbles
which developed at the global level) which in turn is likely to have increased land revenues
accruing to the Chinese government.
Third, positive productivity shocks derived from China’s WTO accession in 2001. As part
of the preparation for the WTO accession – and in consideration of market opening and increased
foreign competition which would have followed – a wave of domestic restructuring and market
liberalization resulted in enhanced levels of efficiency and productivity.139 WTO accession gave
better market access to Chinese exporting firms and at the same time enabled the country to place
legal restraints on the recurring trading partners’ responses in reprisal to surges of imports from
China. The employment expansion in the export sector allowed to absorb the labour shed by state-
owned firms and thus to contain wage pressures. In addition, acceptance of the terms of entry
into the WTO sent a signal to foreign investors of a full commitment of China to the international
trading system, further encouraging the inflow of foreign direct investment to the country. This in
turn resulted in technology transfers and further enhanced China’s potential growth. Hence both
demand and supply factors had a positive impact and contributed to widen the Chinese current
account surpluses.
137 Ma and Yi (2010), p. 8. 138 Ibid., p. 9. 139 Ma and McCauley (2013), p. 9.
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5.2 Sectorial breakdown of Chinese savings
5.2.1 Overview
It’s worth now examining the breakdown of China’s gross national savings by its components:
corporate, household and government savings. The aggregate saving rate is an income-weighted
average of all sectors’ average propensities to save. In other words, the contribution of each sector
to the aggregate saving rate depends on two factors: its income share in the economy and its
average propensity to save from its own income. In China, households, firms and the government
have all been high savers. However, taken individually none of these three components is an
exceptional saver by comparison to its global counterparts. Conversely, as reported in Figure 51,
what makes China’s aggregate saving rate exceptionally high is precisely the combination of these
three high savers.140
Figure 51. Sectorial breakdown of Chinese savings, 1992-2008
Source: elaboration on data from Ma and Yi (2010)
Some observations are worth highlighting. First, the household sector is the largest
saver, followed by the corporate sector. In 2008, the former accounted for 44% of gross Chinese
savings, while the latter for 35%. The government sector accounted in turn for the remaining 21%.
Second, between 1992 and 2008, the major incremental contributions have come from the
corporate and government sectors, both accounting for two-fifths of the overall growth –
amounting to about 17 percentage points of GDP over the whole considered period. The
household sector has accounted for the one remaining fifth. Third, the role of each component in
substantiating the surge of gross savings has changed over time. The corporate sector’s saving
140 Ma, McCauley, and Lam (2013), p. 74.
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increased between 1998 and 2004 from 13.3% to 23.5% of GDP but then decreased and plateaued
to a level of 18.8% of GDP. On the contrary, the household sector’s savings decreased in the
nineties from 20.3% of GDP in 1992 to 16.6% of GDP in 2001, but then increased to reach 23.4%
of GDP in 2008. Similarly, the government sector’s savings began growing at the end of the nineties
and increased from 2.6% of GDP in 1999 to 11.0% of GDP in 2008. Thus over the period 2000-2008
when the Chinese savings surged, the government sector accounted for half of the overall growth,
the household sector for one third and the corporate sector for one sixth. It’s worth now discussing
evidences and interpretations on the sources of corporate, household and government savings.
5.2.2 The corporate sector
As discussed above, corporate savings doubled their consistency as a ratio to GDP between 1992
and 2004, but then trended down. On the whole considered period, this component has been the
most important contributor to the increase in Chinese gross savings, but its role has diminished
over the 2000s. Corporate savings can consist in two parts: depreciation and retaining earnings.
Low dividend payments by Chinese enterprises – resulting in high net earning retained at firms –
could thus contribute to explain the surge in corporate savings over the period. In this perspective,
the case that most of the net earnings were retained by firms in China should be evidenced and
explained. Two main explanations have been suggested: financial underdevelopment and poor
corporate governance.
According to the first explanation, the limited access to external finances would have
forced firms to store up cash and build up liquid internal funds to hedge uncertainties and finance
expansion. In this regard, the evidence is somehow mixed. On the one hand, Song, Storesletten,
and Zilibotti (2011) show that the transition from large and inefficient state-owned enterprises
with access to financial markets to highly efficient domestic private enterprises with limited access
to funding and thus largely dependent on self-financing led to a rising overall level of corporate
savings coupled with a reduced level of investment demand, and contributed to the expansion of
the current account surplus. On the other hand, Ma (2007) and Hale and Long (2010) document
that a relative development of China’s financial system have occurred in recent years, and that
private firms have improved their access to external finance, either formally and informally.
According to the second explanation, poor corporate governance both at private and
state firms would have resulted in low dividend payments. Also this explanation doesn’t seem to
be fully convincing. Ma and Yi (2010) underline that there is little or nil evidence suggesting that
the dividend behaviour of private Chinese firms differs from those in the rest of the world.
Moreover, state-owned enterprises were not required paying dividends precisely thanks to a
government policy, and thus in this case it would not be appropriate to speak of poor corporate
governance.141
141 Ma and Yi (2010), p. 11.
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Therefore, it seems more likely that Chinese corporate savings as a ratio to GDP
increased over the nineties up to the mid-2000s due to an absolute-value surge in corporate
profits rather than to an increased percentage of profits retained at firms. In this regard, Ma and
Yi (2010) report an overview of the main interpretations. One first group or arguments focuses on
the possibility that the high level of Chinese corporate earnings is mostly inflated by government
distortions designed to subsidise the corporate sector and thereby promote exports and growth.
In this regard it is highlighted how the strong presence of monopolies – due to the lack of
competition policy of its weak enforcement – is likely to have boosted profits of mostly state firms.
Other factors thought to have inflated corporate earnings are market distortions such as
restrictions on rural labour migration, subsidies for energy inputs and other subsidies, below-
market prices of land and other assets.142
This approach however doesn’t match with the recent evolution of Chinese corporate
sector. Beardson (2013) describes the way in which China’s economy was transformed over the
last three decades. In the 1980s the dominant industrial component was the state-owned
enterprises, which was later gradually superseded firstly by joint ventures or foreign-funded
enterprises and then by the indigenous private sector. While in 1979 the private sector accounted
for about 3% of GDP, by the mid-2000s it was estimated at a level of about 70% or even 80%.
Conversely, the market share of the big state-controlled enterprises fell over time. Given that the
economy grew from 1980 to 2010 by around 10% annually in real terms, this means that the
private sector grew on average by over 20% annually for three decades. Ma and Yi (2010) confirm
how over the 2000s it has been China’s less subsidized and more efficient local non-state firms
that have been gaining both market and profit shares. In this period the performance of indigenous
private firms doubled both relative to the share in total industrial profits (from 20% to 43%) and
the share in industrial sales and assets.143 At the present, as described in Beardson (2013), “state
companies have most of the assets, fill oligopolistic and this profitable economic positions, receive
virtually all bank credit (and at preferential rates), represent most of the stock market
capitalisation and generate most of the profit”, while private enterprises “constitute most of the
companies, provide most of the jobs, dominate exports, represent over two-thirds of economic
activity and drive the economy”.144 Therefore, while government distortions and subsidies are
likely to have somehow inflated earnings at the state companies, they cannot be considered a
primary factor behind the overall surge in China’s corporate saving, especially in recent years.
A more convincing group of arguments focuses on the contribution of the structural
demographic and economic factors discussed before. Following this perspective, efficiency gains
from corporate restructuring and an expanding private sector have intensified competition and –
via a higher level of productivity – lifted corporate profits and drove economic growth. Moreover,
142 Ibid., p. 12. 143 Ibid., p. 13. 144 Beardson (2103), p. 59.
93
the prolonged rural-urban labour migration, heightened by a compressed demographic transition
and a large pool of surplus labour have restrained wage growth and thus boosted corporate
profits. Other key institutional reforms, such as the China’s accession to the WTO, also played a
major role in enhancing overall productivity and enabling higher profits. Furthermore – as
discussed before – the dynamics of exchange rates contributed in shaping corporate savings.
5.2.3 The household sector
Household savings first fell from 20.3% of GDP in 1992 to a low of 16.6% of GDP in 2001 before
markedly increasing to 23.4% of GDP in 2008. Over the whole considered period, this component
have contributed only three percentage points to the 17 percentage point rise in the aggregate
saving rate. However, its role has largely increasing over the 2000s when China’s savings surged.
Ma and Yi (2010) underline how this overall modest contribution has been the consequence of
two competing forces: a 10 percentage point decline in the household share of income and a 10
percentage point rise in its average propensity to save from its disposable income. Both forces
have led to a marked decline in China’s private consumption share in GDP.145 With regard to the
first one, it is documented that in China a big drop in the household share in gross national disposal
income has occurred over the nineties and 2000s. This decrease is mainly attributed to a declining
labour share in income, which alone account for about 60% of the overall decline in the household
income share. This trend can be explained as a combined consequence of the compressed
demographic transition, the prolonged process of absorbing surplus rural labour, a lagging labour-
intensive service sector and difficult financing conditions for small firms.146
Despite the documented drop in household income share, household saving still rose as
a share of GDP over the 2000s, due to a much higher personal propensity to save in this period.
The household average saving propensity increased from 27.5% of disposable income in 2000 to
39.9% in 2008.147 Ma and Yi (2010) report four major interpretations of household saving
behaviour. First, saving rate can be influenced by interactions among economic growth, income
level and demographic changes. In particular, record economic growth, a sharp decline in the
Chinese youth dependency rate, the expected rapid ageing of the population and
saving/consumption habit persistence may have contributed to a rising personal saving
propensity.148
Second, the role of precautionary saving motives is underlined. A major role may have
been played in this regard by the large scale-corporate restructuring and downsizing occurred
between mid-1990s and mid-2000s, in increasing income uncertainties and weakening the
enterprise-based social safety network. In addition, the government’s lack of proper social services
may have contributed in inducing people to save a large proportion of their income. As effectively
145 Ma and Yi (2010), p. 17. 146 Ibid. 147 Ibid., Table 4, p. 17. 148 Ibid., pp. 18-19.
94
summarized by Beardson (2013) due to a lacking effective social security, “most people save for
future hospital bills, school fees, their son’s dowries to their future wives’ families, housing or
retirement – precautionary saving.” To the lack of social security, a low financial sophistication is
often added as a possible source of precautionary savings. In this regard, Beardson (2013)
underlines how Chinese parents, “allowed only one child, face old age with reduced family
support, and the unsophisticated nature of the financial system offers a limited and ineffective
selection of financial products to meet public social security needs”.149
Third, liquidity or borrowing constraints is often identified as an additional important
determinant of the rising personal saving propensity. However, Ma and Yi (2010) argue that the
availability of consumer credit does not appear to be a major binding constraint to consumption
smoothing over the considered period, given that bank loans to the household sectors have
substantially expanded, reaching 15% of the total outstanding bank loans in the late 2000s from
less than 1% in the late 1990s.150 Finally, institutional changes such as pension reforms and private
home ownership are often cited as major determinants of personal saving behaviour. As already
discussed, the 1997 personal reform led to a reduced level of pension wealth while the
introduction of private home ownership significantly triggered demand for housing assets, thus
further boosting household savings.
5.2.4 The government sector
As discussed before, the government sector has been the smallest saver in China but a major
contributor the rise in national savings. Over the whole considered period its savings more than
doubled, from 4.4% of GDP in 1992 to 11.0% in 2008. The rise in government savings has resulted
from the combination of steady government consumption and rising government disposable
income. The sharp increase in government’s disposable income has been the combined result of
four major components: high economic growth, the 1994 tax reform carried out under Premier
Zhou Rongji, increased land sales and greater social welfare contributions from both the corporate
and household sectors.
Over the 2000s most of the government income gain has been saved and invested rather
than consumed. The average propensity to save of the government has increased from 17.2% in
2000 to 45.3% in 2008. Ma and Yi (2010) report three major explanations of why the Chinese
government has saved and invested and not consumed most of its rising income. First, the
anticipation of rapid population ageing and the 1997 pension reform prompted increased pension
contributions by the corporate and household sectors, with the aim to build up pension assets to
partially prefund future pension benefits. Much of the government disposable income has indeed
been parked under various pension funds administered by the government. Second, local Chinese
government officials have incentives to start new investment projects, as promotions have been
149 Beardson, p. 68. 150 Ma and Yi (2010), p. 17.
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mainly determined by performance indicators such as economic growth in their respective
jurisdictions. This might have led to a tendency to invest more rather than to provide additional
public services, thus boosting government savings. Third, the so-called federal fiscal imbalance
issue is often cited as a major explanation: while a rising share of fiscal revenues is appropriated
by the central government, the preponderance of the social expenditure burden remains on the
shoulders of the less well-funded local governments.151
5.3 Adjustment in gross financial flows and net imbalances
5.3.1 Future prospects of shrinkage of Chinese domestic savings
The sizeable income windfalls originated in favourable productivity and demand shocks which over
the past two decades have enabled the Chinese strong economic development and the
accumulation of large current account savings are disappearing and are likely to progressively fade
in the next years. In Ma, McCauley and Lam (2013), these developments are effectively
summarized as following:
“Both domestic demographics and global growth will count. As surplus rural labour
diminishes, the young labour force cohort contracts and the population ages, real wages will
continue to rise, making Chinese exports less competitive, while lifting the labour share and
squeezing corporate savings. Externally, weaker global growth prospects may prove less
supportive to export demand, forcing policy to emphasize domestic absorption. A rising labour
share also points to a rising personal consumption share, a lower domestic saving rate, and
possibly slower domestic investment, amounting to what is called a domestic rebalancing.” 152
As a consequence, China’s aggregate saving rate could already be plateauing and even
decline over the coming years, causing the current account surplus to remain at the level of about
2% of GDP observed in 2011 and 2012 – or further shrink. It’s worth analysing the expected trends
of the structural factors underlying past Chinese imbalances – discussed in the previous
paragraphs– in order to bring argument sustaining this forecast. First, the phenomenon of large-
scale labour retrenchment from state-owned enterprises observed over the 1990s and 2000s is
considered to have been reaching its conclusion. Moreover, further improvements in the social
safety network provided by the government are expected to be introduced in the following years.
As a consequence, income uncertainties for households should become less pronounced. This
process overall will thus dampen the incentives for private savings both by household and
corporate sectors.153
151 Ma and Yi (2010), p. 24. 152 Ma, McCauley and Lam (2013), p. 73. 153 Ma, McCauley and Lam (2013), pp. 76-77.
96
Second, China is projected to enter a phase of accelerated population ageing over the
2010s and 2020s. Ma, McCauley and Lam (2013) argue that “the favourable demographic tailwinds
are now at least fading if not turning around into headwinds”.154 China’s working age population
may have already peaked and is likely to shrink in future years. The consequences of these
developments on the patterns of overall net saving are not sharp. On one hand, an aging
population is likely to spur the level of household precautionary savings. On the other hand, while
the growth of labour force will decline, the rate of investment is likely to remain at a sustained
level in order to build up the physical capital stock and pension assets in preparation for the ageing
of the population as well as to accommodate the ongoing urbanization process.
Third, while the rural-urban labour migration away from agriculture is likely to continue
in the years ahead – as the urban share of population is expected to rise to 60% by 2020 – there
are evidences that China is approaching the “Lewis turning point” at which the economy has
absorbed the surplus farmers to a considerable extent, and industrial wages need to rise to attract
further migrants into industry. As a consequence, wages are expected to rise faster relative to
productivity pushing up unit labour costs, raising labour share of income and depressing corporate
earnings. Fourth, in light of the prospect of prolonged below-trend global economic growth, the
earlier WTO dividends may as well diminish or even vanish. Foreign demand is likely to remain
subdued in the coming years, and as a consequence global markets will provide fewer vents for
China’s surplus savings.155
5.3.2 Dynamics of gross financial flows and net balances
That China is already undergoing a period of adjustment is evident from the available data. Figures
52 and 53 show the dynamics of China’s cross border capital inflows and outflows. As underlined
by Okazaki and Fukumoto (2011), on the whole capital flow other than transaction on current
accounts and direct investments to – and lately from – China had been relatively small, due to the
strict control of foreign exchange on capital account transactions.156 However, it can be noted how
the volume of capital transaction related to foreign banks loans strongly increased after China
joined the WTO. Capital inflows to China overall doubled as a ratio to GDP between 2000 and 2007,
surging from 34.4% to 70.4% of GDP. Of this 36 percentage points rise, two fifths can be attributed
to an increase in exports of goods (+68.0%), two fifths as well to an increase in non-resident bank’s
lending (14.4 times higher in 2007 than in 2000), and the remaining ten per cent to all other
components. Over the same period, capital outflows from China rose from 32.6% to 57.7% of GDP
(corresponding to a 77% increase). Of this 25 percentage points increase, one third can be
attributed to a rise in imports of goods (+44.5%), more than half to a rise in foreign banks’ lending
(11.5 times higher in 2007 than in 2000), and the remaining 12% to all other components.
154 Ibid., p. 77. 155 Ibid. 156 Okazaki and Fukumoto (2011), p. 9.
97
Figure 52. Balance of payments of China, capital inflows (ratio to GDP), 1990-2012
Source: elaboration on China’s State Administration of Foreign Exchange data
Figure 53. Balance of payments of China, capital outflows (ratio to GDP), 1990-2012
Source: elaboration on China’s State Administration of Foreign Exchange data
In confirmation of the rising international integration of China, it’s to be underlined the
extent to which the fluctuations of international financial markets brought substantial impacts to
Chinese markets, especially in 2008 and 2009. Between 2007 and 2009, both capital inflows and
outflows decrease by one third, plummeting to 47.0% and 38.2% of GDP respectively. Again, the
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98
major role in adjustment is represented by movements in export/import of goods and foreign
banks’ loan, with a percentage proportion on the overall adjustment’s size similar to that observed
in the previous period. Over the period 2007-2009, the consistence of export and import of goods
decreased by 31% and 26% respectively. Foreign bank’s loans decreased by 59% and 58% as regard
to capital inflows and outflows respectively.
A difference in trend between capital inflows and outflows can be observed in the 2009-
2012 period. After having revived in 2010, capital inflows to China decreased in 2011 and 2012, to
return in that year to the exact same level observed in 2009. On the contrary, capital outflows rose
in 2010 and have then remained stable at this level, ending in 2012 14.3% higher than in 2009.
This has enabled an adjustment with respect to the relative size of capital inflows and outflows in
the balance of payments, this resulting in narrower net current account and financial account
balances. If in 2007 total capital inflow to China were equal to 70.4% of GDP while total outflow
to 57.7%, in 2012 the former are equal to 46.6% of GDP and the latter to 44.5%. What is the reason
for this difference in trends? While exports of goods and services have remained stable between
2009 and 2012, imports have increased by 10.8%. Moreover, while capital inflows registered on
the financial account have decreased by 3%, capital outflows have increased by 27.3%. This overall
increase in capital outflows has been mainly due to a 27% increase in foreign bank’s loans to China
and a 2.4 times increase invoiced over the voice “currency and deposits” held by foreigners in
China (reported in Figure 53 under the voice “others on the financial account”). This latter element
could be interpreted as a signal of an increasing international role of the Chinese currency – most
probably, at regional level.
Figure 54 helps visualize the result of these gross movements on the net balance. Some
points can be highlighted. First, as already discussed, the current account balance has decreased
from peaks of about and even more 10% of GDP observed between the last quarter of 2006 and
the last quarter of 2008 to an average of 2.1% of GDP since 2011. Second, the net capital flows to
China have overall been volatile, due to the combination of a steady and positive net flow of FDI
and a highly volatile dynamics of all other components of the financial account. After the financial
crisis, negative net flows of capital other than FDI have been observed in the second half of 2007
and in the second, third and fourth quarters of 2008. Then, net positive capital flows have been
observed overall between mid-2009 and mid-2011. Recently, net negative capital flows other than
FDI have prevailed between the last quarter of 2011 and the second one of 2013, pushing down
the dynamics of total net capital inflow to China.
Third, from Figure 54 does emerge the extent to which China’s official investors have
revealed a preference for buying insurance from the rest of the world through the country’s
external position. China has indeed invested in safe asset in major reserve currencies, while
allowing foreign firms a large stock of direct investment in the country. This situation is changing
in recent years. Due to the combination of narrower current account surpluses and financial flows,
the amount of surplus capital available to be invested in foreign-currency reserves has gradually
decreased. China was able to invest in reserves 10.3% of GDP per annum in the period 2004-2008.
99
This percentage has decreased to 6.6% in 2009-2011 and to 2.3% between 2012 and the second
quarter of 2013. However, if this has resulted in a lower rate of accumulation of foreign-currency
reserves, this has not changed the overall structure of China’s asset position.
Figure 54. Net capital flows into China (ratio to GDP), 2000-2013II
Source: elaboration on China’s State Administration of Foreign Exchange data
5.3.3 China’s gross external asset and liability positions
In this regard, Figures 55 and 56 report the composition of gross external assets and liabilities.
Between 2004 and the third quarter of 2013, China’s gross assets have been have been mainly
composed by reserve assets (almost entirely held in the form of foreign-currency). Their
proportion on the total has been broadly stable at the level of about two thirds of the total.
Foreign-currency reserves amounted to 66% of total assets in 2004 and 65% in the third quarter
of 2013. Of this gross total of $3.7 billion, 35.3% was invested in US treasuries securities. At that
time, China was the major foreign holder of US treasury securities, holding 22.8% of the debt held
by foreigners and 7.7% of the total US federal debt.157
Conversely, Chinese gross liabilities have been mainly composed by FDI. Their share on
the total has increased from 57.7% on average in the period 2004-2007 to 67.5% in 2009 and have
by then decreased to the level of 60.4% observed in the third quarter of 2013. The resulting short-
equity, long-debt position has shifted macroeconomic risk from China to the rest of the world,
providing steady income on China’s assets and reduced payments during a downturn. Such
insurance is costly, and this is confirmed by the evidence that China have earned over the 2000s
157 Source: US Government Accountability Office and China’s State Administration of Foreign Exchange.
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negative income on its sizeable net foreign assets. Since 2005 China indeed reported international
investment payments in the 0 to 4% range (with the exception of 2008, consistently with the risk-
sharing framework described above).158
Figure 55. Composition of Chines gross external assets (US$ billions), 2004-2013III
Source: elaboration on State Administration of Foreign Exchange data
Figure 56. Composition of Chines gross external liabilities (US$ billions), 2004-2013III
Source: elaboration on State Administration of Foreign Exchange data
One interesting aspect is that related to the evolution of foreign direct investment
toward and from China. Net foreign direct investment has been decreasing since mid-2000s, due
158 Ma and McCauley (2013), p. 17.
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101
not to a decline in foreign direct investment to China, but to a surge of direct investment from
China to the world (see Graph 58). David Shambaugh of George Washington University and
Brookings Institution recalls how the strategy of “going out” – in the sense of a government’s
intervention to encourage and help competitive Chinese enterprises to invest abroad – was
explicitly discussed by Jiang Zemin as early as 1992, and eventually discussed at the Politburo in
2000.159 FDI inflow to China started in 1992 and reached in twenty years the level of about $120
billion per annum, with an average pace of growth of 17.1% per annum. In mid-2000s, however,
also Chinese investment abroad began to surge. FDI outflows from China to the world have started
in 2004-2005 and have reached in 2012 the level of about $85 billion, with the far highest average
pace of 45.7% per annum. Thanks to these developments, in 2012 China was the third world
exporter of foreign direct investments after the US and Japan (or the fourth one if we consider the
European Union as a whole).160 If these trends were to continue unchanged, China will turn in
future years from being a net importer to be a net exporter of FDI and likely of capital flows overall.
Figure 57. FDI to and from China (US$ billions), 1980-2012
Source: elaboration on UNCTAD data
159 Shambaugh (2013), pp. 174-175. 160 Source: UNCTAD.
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5.4 Prospects of future evolution of Chinese economy and society
5.4.1 The Chinese generations of leadership161
The succession of various periods in the development of the government of the People's Republic
of China – and consequently the succession of various periods with respect to economic
development issues – can by analysed making reference to the sequence of distinct generations
of Chinese leadership. In the Communist Party's official discourse, the identification of generations
of leadership was set down during the leadership of Jiang Zemin and publicised at the end of the
nineties. From Jiang’s era forward, this approach has been maintained and further
institutionalized. Each of these generations has faced different political, economic, and social
problems and has left a different imprint in shaping the development of China. Although it is not
a goal of this research to study in deep the history of the People’s Republic of China's, it’s worth
briefly outlining the sequence of its leadership, in order to better contextualize the economic
developments of the nineties and 2000s – in particular, to put in a broader context the forecasts
of adjustment and future evolution of saving patterns and current account imbalances highlighted
before – and have a better understanding of the issues which will need to be faced by Chinese
government in the current and next decades.
The first generation of Leadership (1949-1976) was composed by the leaders that
founded the People's Republic of China after the Communist Party’s victory in the Chinese Civil
War. It was composed by Mao Zedong – who was the autocratic leader for most of the period, and
thus must no doubt be considered the “core” of the first generation – along with Zhou Enlai
(Premier from 1949 to 1976), Liu Shaoqi, Zhu De and Chen Yun, and later Lin Biao and the Gang of
Four. Also Deng Xiaoping played a key role in the first generation at various times. Deng Xiaoping
is officially identified as the “core” – or “paramount leader” – of the second generation of
leadership (1976-1992), though he was never formally the leader of the party during this period.
Deng maintained his position until 1992 when he resigned, and directly chose the leaders who
played the major roles in the government: Hu Yaobang (Secretary General of the Party in 1982-
1987) and Zhao Ziyang (Premier in 1980-1987 and Secretary General of the Party in 1987-1989)
who were demoted on the eve and during the Tiananmen Square protests of 1989 and substituted
with Li Peng and Jiang Zemin.
The second generation of leadership is the one that began reforming the Maoist
economic and social system and it’s responsible of the shaping of a pattern of development in
contrast to that of the “Washington Consensus”. To the latter – characterised by free market,
private ownership, free trade and weak government – was opposed the so-called “Beijing
Consensus”, characterized by strong government, strong intervention of the State in the economy,
161 For this paragraph, reference is made to a series of lectures held by Professor Bogdan Góralczyk – former Polish Ambassador to Thailand, Philippines and Myanmar – at the Centre for Europe of the University of Warsaw in November 2012.
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and the introduction of elements of free market provided they were heavily regulated by the
government. This generation was responsible of important reforms in agriculture, the
controversial one-child policy, and a first stage of market and industrial reforms – most
importantly, the creation in 1978 of the first four Special Economic Zones in Shenzhen, Xiamen,
Shantou, and Zhuhai all in in Guangdong province. One of Deng’s most important heritages is often
identified in the adoption of a strongly pragmatic approach to the political and economic direction,
which can effectively be summarized in the proverb – either composed or made famous by Deng
himself – according to which “it doesn't matter if a cat is black or white, as long as it can catch
mice, it's a good cat”, a metaphor for the market mechanisms, to be welcomed as long as they
provided economic development, though being in contrast with the Maoist official ideology.
The third generation (1992-2003) viewed Jiang Zemin as its “core” in the role of Secretary
General of the Party – and President of the Republic since 1993, when the two positions were
merged. Li Peng and Zhu Rongji juxtaposed Jiang as prominent leaders, the former in the role of
Premier between 1978 and 1989 and the latter as Li’s deputy in the same period and Premier in
1998-2003. During the third generation of leadership the market was allowed to prevail over the
plans and acknowledged as the main driver of development. Zhou Rongji, in particular, was
responsible of a large restructuring of the Chinese economy, adopting the reforms that allowed
China to adjust to the globalization pattern, fully open itself to the world and to eventually access
WTO in 2001. The Chinese model of development adopted by this generation of leadership was
focused on the commitment to target economic growth without regard to negative side effects.
The main drivers of economic growth itself were strong levels of exports of manufactured goods
and the full exploitation of cheap labour force, supported by large FDI inflows and the government
intervention.
During the fourth generation (2003-2012), leaded by Hu Jintao (Secretary General of the
Party and President of the Republic) and Wen Jiabao (Premier), the problems linked to this
development model began to be increasingly evident. Between the others, a growing stratification
of the society (mirrored in a Gini coefficient risen from 29.1 in 1981 to 42.6 in the period 2002-
2008162) which led to a huge number of strikes, a tremendous level of corruption, a poor social
security network, important environmental and pollution issues, a number of problems related to
the fast ageing of the population, and others related to a quick urbanization. With the intention
to start address these issues, in 2005 Hu Jintao introduced the strategic target of building a so-
called “harmonious society”, an approach which reflects the need to reach a more balanced
society in the subsequent years, and fits into the framework of the concept of “harmonious world”
by which Hu intended the general willingness of China to rise without becoming a threat to the
existing global order.
162 Source: World Bank data.
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The fifth generation is currently in power. This generation sees Xi Jinping as Secretary
General of the Party and President of the Republic and Li Kequiang as Premier. In the years prior
to their coming to power a strong debate spread in political and academic environments on the
path that should have to be followed in the future by China and by its new leadership.163 The
dominant approach – a realistic one, following the approach of Deng Xiaoping – harks back to the
willingness of Jiang Zemin and Zhou Rongji to create from 2000 to 2020 a “moderately well-off
society”. In this perspective, the goal of quadrupling the gross domestic product in twenty years
was accompanied to that of quadrupling GDP per capita over the same period. To reach this goals,
it’s recognized the need to change the development model from one dominated by export-led
growth, cheap labour, FDI support and government-led reform to one characterized by domestic
consumption-led growth, sustainable development even at lower rates of GDP growth, FDI
investment abroad to allow China to “go global”, social cohesion and stability, green rather than
carbon economy, and technological innovation.
5.4.2 Towards a new growth model: goals and challenges
Beardson (2013) considers the previous model of development to have already been completely
overcome, as effectively summarized as following:
“China is no longer the cheapest country in which to manufacture. Currency movements
have disadvantaged it, wages have risen, social and environmental costs are increasing. Export
margins were always thin, but with rising costs there is little buffer available to absorb the impact.
[…] China needs to handle deep unemployment and simultaneously reorient itself to address a
declining labour force and a rising cost structure. If the old cheap export and fixed investment
model is broken, the alternative should be a combination of the long-awaited innovation and
domestic consumption.” 164
The possibility of a future recovery of the old low-cost manufacturing model is
considered to be highly unlikely if not impossible at all. Several changes would be required for the
past conditions to return, including “a deliberate currency depreciation, a conscious abatement of
environmental controls, a strong recovery in Western demand for manufactured goods, a recovery
in the currencies of China’s main export competitors, ideally a halt in the one-child policy with new
incentives to produce more children, and a slow-down in Western-style labour legislation”.165
However, not all of these changes are within the government’s power to effect, even if desired. In
this perspective, Beardson (2013) sees the challenges that the fifth generation of leaders will have
to face as twofold. First, the government will have to find a way to build a more dynamic domestic
economy. This could be achieved by recycling more effectively the large cash surpluses within state
163 For a deep review of major schools of thought on China’s identity and future evolution, please refer to Shambaugh (2013), chapter 2 (“China’s global identities”). 164 Beardson (2013), p. 77. 165 Ibid., p. 403.
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enterprises and, in particular, by persuading the households to reduce their savings in order to
consume. Second, it will have to find a way to transform China in a high-quality, more innovative,
and highly competitive export economy.166
The first route – to mobilize household savings – can be addressed by tackling the causes
of excess saving. Beardson (2013) outline a series of ways to reach this goal. Large consequences
could be obtained through an expansion and a further liberalization of the service sector, in order
to create more jobs and at the same rime raise wages as a percentage of GDP. This, however,
requires skills which are not currently taught. In addition, measures to encourage consumer
spending might include increasing the value of the renminbi and raising interest rates. Raising the
level of interest rates would be helpful in discouraging excess manufacturing investment and
returning more revenue annually to household depositors, who could spend it. However, raising
interest rates would reduce corporate profit, increase losses for the central bank in holding US
Treasury securities, and hit government finances as virtually all public debt is domestic. Further
appreciating the currency would reduce the extent to which an implicit exchange rate subsidy is
imposed on the shoulders of households – which might otherwise buy imported goods at lower
prices. It would also weak inflation, encourage higher-quality exports, and drive productivity to
increase. However, it would cause as well huge losses on US Treasury securities held by China.
Another important way to mobilize household savings could consist in enhancing the
social security network as well as the insurance market, in this way raising the level of confidence
on future outcomes.167 Beardson (2013) underlines how social initiatives, particularly in health,
would have a huge effect: “as so much of the country’s untapped household savings is for
unpredictable events, such as illness of hospitalisation, some form of insurance against any such
eventuality should release 10, 50 or 100 times as much savings as the same money spent on
infrastructure”.168 However, any initiative to create confidence in households may not produce
the desired effects if not over a long period of time, also because of the harsh climate that
prevailed as a result of the global crisis.
Therefore, mobilising personal savings to create domestic spending seems to be
problematic. “Given these factors – government failure to prioritise social provision, […] gloomy
economic news, low currency value, low interest rates and low economic impact on wages – the
domestic consumer economy is unlikely to boom in the near term”169 and, as a consequence,
Beardson (2013) considers more likely that the government will choose to address the highlighted
challenges via the second route – to upgrade innovation and knowledge skills – or by a
combination of the two routes. However, other problems may be found on the second route.
Clearer property rights, less political risk for private business, the end of the regulation which
166 Beardson (2013), pp. 403-404. 167 Ibid., p. 404. 168 Ibid., p. 68. 169 Ibid., p. 69.
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restricts rural people’s rights to become urban, deregulation and dismantling of monopolies, all
are elements that are considered to be between those essential for the success of this process.
Even if “failure to reform and an inability to create the innovation economy will directly prejudice
China’s long-term growth”, strong opposition in this regard might come from the political sphere,
in that “property rights and state ownership are not academic economic debates but issues that
affect political power”.170
Hu Angang, economics professor at Tsinghua University and Director of the Center for
China Study at Tsinghua Chinese Academy of Sciences, agrees with this approach and argues that
“[to] build a well-off society along all dimensions and construct a harmonious socialist society,
China must continue the path of scientific development”.171 This suggestion is inserted in the
framework of a road map for China’s modernization in the medium term. A series of strategic
economic and social development goals to be reached in 2020 are outlined – on the basis of what
decided by the Eleventh Five-Year Plan (2006-2010) – with reference to the spheres of economic
growth, people’s wealth, human development, science, technology, education, sustainable
development, harmony and stability, democracy and rule of law, soft power, and hard power.
It’s worth considering some of these goals, with respect with the issues under
consideration in this research. First, China should complete the industrialization process. In this
regard, Hu (2011) argued that it’s likely that China’s achievements will reach and exceed that set
in 2002 by the Sixteenth Party Congress – among the others, to quadruple the 2000 GDP by 2020
and to significantly increase the level of per capita GDP. A particular attention, in this regard, is
placed on the specific target to “make people wealthy”, that is to raise China’s human
development index (HDI) to the upper middle or even high level (from 0.76 in 2003 to 0.88 in 2020)
and to raise per capita gross national income (GNI) from $4,000 in 2010 to $8,000-$8,500 in 2020.
Second, China should maintain macroeconomic stability. In this regard, it’s underlined that
international payments should be maintained at a “roughly balanced” level.172
Third, a new road of industrialization should be followed. In this regard, Hu (2011)
underlines how for China it is “imperative to optimize the industrial structure, reorganize and
transform traditional industries, develop specialty industries, stimulate high-tech and high-value-
added industries, and raise the proportion of the service industry in the production and
employment structures”. Fourth, a more open and competitive economic system should be built,
ensuring the opening of neighbouring, regional, and multilateral free trade zones, thus expanding
the geographical space for China’s development and sustaining China’s export. Moreover, China
should “edge into the front ranks in terms of trade in services and become a power in foreign
investment”. In this regard, it is underlined how China should enhance international
competitiveness, through the emergence of “a number of enterprises commanding core
170 Beardson (2013), p. 78. 171 Hu (2011), p. 140. 172 Ibid., pp. 144-145.
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technologies and boasting internationally known brands and international competitiveness”. In
this perspective, it’s sketched how the number of Chinese enterprises among the world’s top 500
should increase from 19 in 2006 to more than 120 in 2020. Other important targets with respect
to the aim of this research are those related to social harmony and stability goals. In this regard,
Hu (2011) argued that China should set up a basic system of social security by 2020. Over 85% of
urban residents should be covered by unemployment insurance, medical insurance, and basic old-
age insurance, while the coverage rate of rural medical insurance should reach 100%.173
These goals have been recently brought back up at the official institutional level of
debate. Within the Twelfth Five-Year Plan (2011-2015)174 the target of moving coastal regions from
being the world's factory to hubs of research and development, high-end manufacturing, and the
service sector was underlined. In his report at the Eighteen Party Congress in 2012, President Hu
Jintao reiterated the main goals and targets for China to be met up to 2020.175 Among the others:
complete the building of a moderately prosperous society and deepening reform and opening up;
raise overall living standards and improving the people’s wellbeing; change the growth model and
implement the strategy of innovation-driven development; deepen economic structural reform –
in particular, allowing public ownership to take diverse forms, deepening the reform of state-
owned enterprises, improving the management of all types of state assets, investing more of state
capital in major industries and key fields, accelerate the reform of the fiscal and taxation systems
with the aim of raise the level of local and central government’s revenue, and taking steady steps
to make interest rates and the RMB exchange rate more market-based.
The same approach has been recently confirmed within the works of the Third Plenary
Session – more commonly referred to as the “third plenum” – of the Eighteen CPC Central
Committee, held in Beijing from November 9th to 12th 2013. Between the most important
resolutions taken or reaffirmed by the Central Committee headed by Xi Jinping, we underline the
decisions – relating to the economic sphere – to “further relax investment restrictions and
accelerate construction of free trade zones”, to “allow more private capital into the market to
develop a mixed ownership economy”, to “promote market-oriented reform in state-owned
enterprises by further breaking monopolies and introducing competition”, and to “open up the
banking sector wider […] by allowing private capital to set up small and medium-sized banks”. At
the social level, we underline the decisions to “loosen the one-child population policy, allowing
couples to have two children if one of them is an only child”, to “build a more impartial and
sustainable social security system, encompassing an improved housing guarantee and supply
mechanism” in a way to “enhance regulation of income secondary distribution through taxation”,
to “accelerate the reform of [the] hukou system, or household registration system, to help farmers
173 Hu (2011), pp. 144-152. 174 An English translation of China's 12th Five-Year Plan 2011-2015 can be downloaded from the website of the British Chamber of Commerce in China. 175 The full text of the report of Hu Jintao to the 18th CPC National Congress (held in Beijing on 8 November 2012) can be downloaded from the China Internet Information Center website.
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become urban residents”, and to “improve the mechanisms for coordinating urban and rural
development in an effort to allow farmers to share the fruits of the country's modernization”.176
Surely there are numerous external and domestic challenges faced by China in
addressing these goals of development. Hu (2011) underlines, in particular, a series of major
shortcomings on the road to change the Chinese growth model. First, the long-term deterioration
of the income distribution – related to the decline of the proportion of household income to gross
national income – and the consequent polarization of the Chinese income distribution. Second,
low birth rates and the increasingly aging of the society. Third, serious environmental pollution
issues, resulting in grassland degradation, desertification, soil erosion, salt alkalization, and land
contamination. However, Hu (2011) let out an optimistic view of the process of China’s
transformation and modernization. He concludes that “[although] international and domestic
uncertainty and instability have increased, there have been no fundamental changes to the
favourable internal and external conditions for China’s economic development”.177 The issue of
criticalities and threats linked to the Chinese future development surely constitute a highly
controversial issue and a starting point for future research.
176 The full text of the decisions taken by the Third Plenary Session of the 18th CPC Central Committee can be downloaded from the China Internet Information Center website. 177 Hu (2011), p. 161.
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Conclusions
Evidences on global imbalances in the pre-crisis years
Global imbalances – measured as the sum of the absolute values of current account balances of
all countries of the world – have widened in the decade 1996-2006 from about 2% to 5.7% of world
GDP. The expansion of global imbalances begins in 1997, in the aftermath of the Asian crisis, when
the Ea st Asian developing and newly industrialized countries178, together with China, began to run
persisting current account savings, shifting from a posture of net capital importers to one of net
capital exporters. This position was aimed at pursuing an export-led growth strategy by
maintaining an undervalued exchange rate, while at the same time accumulating stocks of
international reserves as buffers against the possible recurrence of financial and currency crises.
In the East Asian countries, the surge in net savings can be explained by a collapse of investment.
Conversely in China it is explained by an extraordinary surge in domestic savings up to a level of
about 53% of GDP in 2008, in a way capable of overtaking the – also booming – trend of
investment.
Around 2000 also the oil exporters as a group179 began running large current account
surpluses, driven by the increase in oil demand and price, and became net capital exporters.
Europe as a group has been in a balanced stance over the considered period, however this position
hides large current account deficits and surpluses run by single member countries. A large
surpluses run by Germany and – to a lesser extent – by other central and northern European
countries have had their counterpart in large deficits run by Spain, the United Kingdom, Greece,
Italy, Poland, France, and other southern and eastern countries.
The United States has been accumulating large current account deficits during the first
half of the 1980s and again from the early 1990s onwards. During this second period, the current
account deficit reached a peak of 6.2% of GDP in the last quarter of 2005. We have carried out a
sectorial breakdown of US’ savings and investment in order to identify the major drivers of this
overall dynamics. It can be underlined in the first place how a persisting decrease in the household
saving rate has characterised the whole considered period. Over the 1990s, a strong bubble-driven
rise in investment rather than a fall in saving drove the saving gap. In this process, a major role
was played by the private sector – business and households – which together swung from financial
surplus into deficit. Conversely, over the 2000s an overall falling trend in domestic savings rather
than a surge in investment drove the widening of the current account deficit. In this case, a major
role has been played by a strong deterioration in the government balance and a surge in household
residential investment, which in turn fuelled another bubble-driven investment cycle.
178 Hong Kong, Indonesia, South Korea, Malaysia, the Philippines, Singapore, Taiwan, and Thailand. 179 Algeria, Angola, Bahrain, Iraq, Iran, Kazakhstan, Kuwait, Libya, Nigeria, Norway, Oman, Qatar, Russia, Saudi Arabia, Trinidad and Tobago, United Arab Emirates, and Venezuela.
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Interpretation of global imbalances
From the described patterns of emergence and widening of global imbalances, a series of critical
research questions do emerge. What are the causes of global imbalances? How the relationship
between large deficits in the US and large surpluses in East Asian and oil-exporting countries can
be described? Have global imbalances had an influence in causing the global crisis and, if so, in
which way? A number of competing models and theories have been formulated in response to
these questions. Underlying all interpretations there is a reflection on the nature of global
imbalances themselves, and in particular on the likeliness of global imbalances to have either bad
consequences – and thus directly increase financial risk – or bad causes – and thus to be
considered as significant signals of dangerous features of the world economy. We propose an
overview of the major lines of interpretation of global imbalances, as well as their comparison and
critical evaluation. As regard to the relationship between global imbalances and the international
crisis, we conclude that the former can be considered an important co-determinant of the latter,
which in turn has eventually forced their adjustment. In this perspective, global imbalances were
not the immediate cause of the crisis, but they created the conditions for its development. In
addition, global imbalances played an important role in spreading worldwide and further
magnifying the effects of the crisis.
In the Global Saving Glut framework – originally proposed by Bed Bernanke – the United
States was forced to accept capital from abroad and adapted its economy to externally-
determined trends in savings and borrowing conditions. We underline how the global saving glut
hypothesis has a strong political dimension in ascribing the main responsibility for imbalanced
patterns of world balances of payments to surplus countries, while minimizing the role played by
the US. It doesn’t propose a satisfactory explanation of the willingness of the United States to
accept the financial flows originating in the surplus countries, nor a discussion of the ways in which
use has been made of such financial flows in the years preceding the global crisis. Moreover, this
approach is not fully supported by the available data.
Therefore, we argue that the GSG hypothesis can only explain one part of the whole
picture, but it should be placed in a broader explanation of the phenomenon of global imbalances
where, in particular, the role of the US’ financial private and public institutions should be much
more stressed. Indeed, global imbalances could only unfold their adverse effects in connection
with a deregulated financial sector in the United States. In particular, the global saving glut would
not have been able to cause the US’ deficit had it not been for the accommodative stance of the
US’ monetary policy. In this regard, we underline how, if it’s true that lower imported inflation and
easy financing conditions decreased the incentive for the Fed to raise interest rates in 2003-2004,
it’s true as well that the Fed was fully conscious about the risks entailed in this policy. Therefore,
we argue that US’ policymakers took an informed choice not to oppose the external trends but
rather to enable the United States to take full advantage of them, regardless of the possible
adverse consequences.
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In contrast to the GSG hypothesis, the framework proposed by the Bretton Woods II
hypothesis effectively proposes a description of the structure of the international monetary
system in which both the saving countries and the US benefited from their commercial and
financial relationship. The BWII hypothesis describes the implicit bargain between East Asian
countries, and China in particular, and the United States, with the former supporting export-led
growth strategies – by undervalued and heavily managed exchange rates, capital controls and
official capital outflows in the form of accumulation of reserve asset claims on the US itself – and
the latter enjoying easy borrowing and consumption conditions and avoiding worrying about its
international investment position. However, we underline how this approach fails in considering
the high costs which are the direct consequences of this implicit bargain.
In this regard, we argue that the win-win relationship inherent in the Bretton Woods II
world entails a corresponding structural lost-lost relationship. Debtor and surplus countries
benefit from their mutual relationship, but from the latter dangerous consequences for both arise
as well. The US-China relationship is an emblematic example. The United States did borne
excessive domestic and external debt and developed an increasingly dependence from China as
regard the funding of its deficit. China did excessively rely on the US’ demand and became highly
vulnerable in terms of exchange rate exposure on its stock of dollar reserves. In this regard, we
argue that the structure of the BWII international monetary system – and the resulting balance of
payments imbalances – has given way, and even contributed, to the development of a financial
environment characterized by a high level of hazardousness which has eventually fully displayed
itself in the outbreak of the crisis.
Valuation effects and the United States’ exorbitant privilege
Current account imbalances are the net result of generally far larger gross financial flows, and add
up year after year to the resulting gross financial positions. Cross-border gross flows and positions
have massively increased since the 1980s and especially in the 1990s and 2000s. It’s important to
underline how gross exposures borne by a country may be capable to carry the risk of financial
instability regardless of the resulting net international stance. We have documented recent trends
of gross financial flows and positions on the basis of evidences from the United States and China.
Such analysis is useful to highlight some important features of the international monetary system
and provide us with significant evidences to understand how could it possible for its centre country
– the United States – to sustain a broad period of continuous large current account deficits.
We document how in the US the current account balance has become an increasingly
minor component of the overall change in the net international investment position. A major
component has instead been represented by huge net capital gains and losses, known in literature
as valuation effects. The role played by valuation effects has been crucial especially in the 2000s
up to the global crisis. Positive valuation effects relax the external constraint of the US, allowing it
to enjoy the exorbitant privilege to run large current account deficits without worsening its
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external position commensurately. In other words, the United States has been able to run larger
and persisting current account deficits, as the deterioration of the net international asset position
has been muted by large capital gains. The US’ exorbitant privilege is a direct consequence of the
asymmetric structure of the international monetary system, in which the United States is the
centre country and the issuer of the international currency. The US’ exorbitant privilege manifests
itself in an exchange rate channel and in an excess return channel.
The exchange rate channel of the exorbitant privilege is due to the fact that US’ foreign
assets are mainly denominated in foreign currencies while US’ external liabilities are mostly
denominated in dollars. It follows that any devaluation of the dollar gives rise to wealth transfer
from the rest of the world to the United States, and thus improves the US’ net foreign asset
position. The excess return channel of the exorbitant privilege consists in the ability of the US to
earn on average higher returns on its external assets than on its liabilities. Excess returns on US’
external assets relative to liabilities can be divided into three components. A composition effect
results from an asymmetric structure of the US’ external balance sheet and is due to the relative
proportion of safe liabilities and risky assets. US’ external assets are indeed less liquid and more
risky than US’ external liabilities and therefore earn a higher premium. We document how, over
the eighties, nineties and 2000s, this structure and the resulting overall pattern of liquidity
transformation have become progressively more pronounced. A leverage effect results from the
size of the US external balance sheet itself. Finally, a return effect results form an excess return
within class of assets.
Adjustment in global imbalances in the post-crisis years
As a consequence of its exorbitant privilege, the United States has been able to avoid normal
balance of payment constraints and consequently to largely postpone the time of adjustment in
its external position. Surplus countries exploited other features of the international monetary
system – in particular, the possibility to manage their exchange rates – to resist pressure and delay
adjustment in their balance of payments. Prior to the crisis, many commentators highlighted the
risks entailed in postponing the needed adjustment. For both surplus and deficit countries, an
abrupt reversion of the conditions that permitted the widening of global imbalances – known in
literature as sudden stop – would have eventually resulted in financial turmoil, currency crises,
output decline or collapses. When the global crisis hit, adjustment was imposed to unbalanced
countries. We document such patterns of adjustment. The current account deficits run by the US
strongly contracted in 2006-2009, due to the combination of a huge drop in private investment, a
huge drop in government savings, and an increase in private savings. The group of deficit countries
of Europe strongly contracted as well. Japan, the East Asian countries and – to a greater extent –
China experienced strong contraction in their surpluses. The position of the surplus countries of
Europe has been contracting to a far lesser extent. Surpluses run by oil exporters have been heavily
contracting in the aftermath of the crisis, but have returned in 2012 to pre-crisis levels. In
aggregate, global imbalances decreased from a maximum of 5.7% of world GDP in 2006 to a
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minimum of 3.7% in 2009, and have slightly recovered to about 4% of world GDP in the period
2010-2012. It’s important to note how this level is still equal to about the double of that prevailing
in the early and mid-1990s. Interestingly as regard to further research and assessment of future
prospects of evolution, we document how after the crisis the aggregate deficit of the rest of the
world has progressively increased. A number of new deficit countries has emerged – in the first
place India, Canada, Australia, Brazil, Turkey, and secondly South Africa, Ukraine and Mexico – and
partially substituted the US and the deficit countries of Europe in absorbing world surpluses.
Empirical evidences form the post-crisis years allow for the possibility to formulate a
more thorough evaluation of the mutual connections between current account imbalances,
financial turmoil and economic crises. They confirm, in particular, that countries with excessive
current account imbalances prior to the crisis also experienced the largest contractions in their
external balance and the sharper output reductions during the adjustment period. This link is
found to be more robust with respect to deficit countries. The distribution of current account
balances at the onset of the crisis is thus confirmed to be a good predictor of the distribution of
macroeconomic outcome during the subsequent adjustment phase. Prior to the crisis, it was
generally accepted that movements in exchange rates would have eventually acted to correct
external imbalances. On the contrary, the adjustment process actually took place primarily
through steep declines in domestic output and demand rather than through changes in exchange
rates, which instead played a very modest role.
Evidences on valuation effects in times of crisis show a reversal of the usual US’
exorbitant privilege – a phenomenon known in literature as the exorbitant duty of the United
States. This is due to the fact that, during the financial crisis, the value of US’ risky external assets
collapsed relative to the value of safe external liabilities. Negative changes in the net investment
international position due to adverse valuation effects have been observed in particular in 2008
and 2011. This phenomenon has implied a wealth transfer from the United States to the rest of
the world, whereby the role of the United States can be interpreted as that of a global insurer. The
EU area, Switzerland and – although at a lesser extent – China are found to have followed a pattern
of wealth transfer similar to that of the US, and can thus be regarded as regional insurers. We
underline the extent to which these findings suggest that the global economy may have moved to
a greater level toward a multilateral system with respect to global liquidity provision. From a
comparison of US exorbitant privilege and exorbitant duty we find that, with respect to the size of
wealth transfers, the former stood at the latter at a ratio of 3.5 to 1 over the period 1980-2012,
and at a ratio of 4.6 to 1 in the decade 2002-2012. Therefore, we argue that over the last two
decades to the US exorbitant privilege rather corresponded a US moderate duty.
Widening and adjustment of Chinese imbalances
A sizable part of this research is devoted to a focus on the China’s contribution to global
imbalances. Given that the main driver of the huge Chinese current account surpluses can be
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found in the dynamics of domestic savings, we first proceed to a discussion of the main causes
underlying the surge in domestic savings over the 2000s. Empirical evidences confirm that
exchange rate movements are likely to have contributed to the pre-crisis expansion and the
subsequent adjustment of the Chinese current account balance. However, currency manipulation
and exchange rate movements alone can’t explain Chinese imbalances. Other major factors can
be identified in large income windfalls from productivity and demand shocks which have been
saved. In particular, we discuss and stress the role of demographic and labour market
developments and key institutional reforms in a wide number of sectors such as agriculture,
industry, pension system, tax collection system, house ownership and property right. We
underline as well the role of corporate restructuring in state-owned enterprises and China’s WTO
accession in 2001.
How have these developments impacted the propensity to save of household, corporate
and government sectors? A sectorial breakdown of Chinese savings shows that households, firms
and the government have all been high savers. What makes China’s aggregate saving rate
exceptionally high is precisely the combination of these three high savers. Between 1992 and 2008,
the major incremental contributions have come from the corporate and government sectors, both
accounting for two-fifths of the overall growth. However, over the period 2000-2008 when the
Chinese savings surged, the major contributions have come from the government sector – half of
the overall growth – and from the household sector – one third.
The interaction between a compressed demographic transition and reforms in
agriculture and industry resulted in a massive rural-urban labour migration, which determined a
persistently falling labour share in income. This in turn raised profits and enabled a higher level of
corporate savings, and simultaneously contributed to restrain private consumption and boost
household saving rate. Other important institutional reforms took place in China over the 1990s
and 2000s. A new pension system reduced pension benefits and increased contributions, whereby
spurring both household and government savings. Reforms of private home ownership and
property market increased incentives to save by households in order to build up private assets in
anticipation of retirement, and set the stage for the expansion of a real estate investment boom
over the 2000s which in turn increased land revenues accruing to the Chinese government.
Moreover, the process of corporate restructuring in state-owned enterprises that started in early
1990s resulted in labour retrenchment and productivity gains, and at the same time made room
for more efficient private firms. Similar positive supply and demand shocks derived from China’s
WTO accession in 2001. These developments boosted corporate savings as well as precautionary
household savings, due to greater job insecurity and expenditure uncertainty imposed to workers.
The favourable conditions which over the past two decades have enabled the
accumulation of large current account savings are likely to progressively fade in the next years. In
particular, the phenomenon of large-scale labour retrenchment from state-owned enterprises is
considered to have reached a conclusion. Moreover, China is approaching the Lewis turning point,
at which the economy has absorbed the surplus farmers to a considerable extent, and industrial
115
real wages need to rise to attract further migrants into industry. Furthermore, the development
of a deeper and wider social security system is expected in future years. Therefore, China’s
aggregate saving rate is likely to be plateauing over the coming years at the current level of 2% of
GDP – or even decline.
Based on the available data we show that China is already undergoing a period of
adjustment with respect to the relative size of capital inflows and outflows in the balance of
payments, this resulting in narrower net current account and financial account balances. This
adjustment has happened in recent years (2010-2012), so after that China has absorbed the
impact of the international crisis. In this regard, we document how Chinese exports have remained
stable between 2009 and 2012 while imports have increased by 10.8% and, in a similar way, capital
inflows registered on the financial account have decreased by 3% while capital outflows have
increased by 27.3%. An important contribution to this latter development is given by a 2.4 times
increase invoiced over the voice “currency and deposits” held by foreigners in China, an element
which may be interpreted as a signal of an increasing international role of the Chinese currency.
As a consequence of the adjustment phase, the current account balance has decreased
from peaks of about and even more 10% of GDP observed in the period 2006-2008 to an average
of 2.1% of GDP since 2011. In addition, net negative capital flows other than FDI have recently
prevailed, pushing down the dynamics of total net capital inflow to China. Due to the combination
of narrower current account surpluses and financial flows, the amount of surplus capital available
to be invested in foreign-currency reserves has gradually decreased. We stress the dynamics of
net FDI as an important part of the overall picture. Net foreign direct investment has been
decreasing since mid-2000s, due not to a decline in FDI China, but to a surge of direct investment
from China to the world, which started in 2004-2005 and has by then increased with a strong pace
of growth. Thanks to these developments, in 2012 China was the third world exporter of foreign
direct investments after the US and Japan. If these trends were to continue unchanged, China will
turn in future years from being a net importer to be a net exporter of FDI and likely of capital flows
overall.
We finally report an overview of the current debate around the prospects of future
evolution of Chinese economy and society, with a focus on the goals and challenges which will
have to be faced by the fifth generation of Chinese leadership. The Chinese government target the
establishment by 2020 of a moderately well-off society. Between the others, the goal to quadruple
by 2020 the 2000 GDP per capita is established. To reach this aim, it’s recognized the need to
change the development model from one dominated by export-led growth, cheap labour, FDI
support and government-led reform to one characterized by domestic consumption-led growth,
sustainable development, FDI investment abroad to allow China to go global and technological
innovation. Two major – not mutually exclusive – routes could be followed by Chinese government
in order to change the growth model. The first way consists in mobilizing household savings by an
expansion and further liberalization of the service sector, higher levels of exchange and interest
rates, and the enhancement of the social security network. The second consists in transforming
116
China in a high-quality, high-tech and high-value-added innovative and highly competitive export
economy. Both routes, however, raise a number of problems of social, economic, and politic
nature.
Summary
The following summary is intended to reiterate the main findings from the different chapters and
to synthetize them into integrated conclusions. Global imbalances – unbalanced patterns of world
savings and investment, which are reflected either in persisting surpluses or deficits in the balance
of payments of a number of major countries – have widened in the decade 1996-2006 from about
2% to 5.7% of world GDP. Huge external deficits run by the United States and – secondly – by a
number of European countries have had their counterpart in huge surpluses run by China, East
Asian countries, oil exporters, and the core countries of Europe. The US-China relationship is
emblematic of the creditor-debtor relationship which is implicit in unbalanced patterns of world
savings and investment, and thus a focus on these two countries is a useful methodological
approach. Prior to the crisis, major drivers of the US’ deficits have been a persisting decrease in
the household saving rate, strong bubble-driven investment cycles, phases of deterioration of the
government budget, and finally a surge in household residential investment. Major drivers of
China’s surpluses can be found in structural demographic and labour market developments, key
institutional reforms in agriculture, industry, pension system, tax collection system, house
ownership and property right, a deep corporate restructuring process in the network of state-
owned enterprises, and China’s WTO accession in 2001. Both the US and China have been able to
largely postpone the time of adjustment in their external unbalanced positions. On the one hand,
in the US huge net capital gains deriving from the currency denomination and the short-equity,
long-debt structure of the US external balance sheet – known as valuation effects – relaxed the
external constraint of the US, allowing it to enjoy the exorbitant privilege to run large current
account deficits without worsening its external position commensurately. On the other, China was
able to postpone its external adjustment by pursuing an export-led growth strategy supported by
a persistently undervalued currency and a massive foreign-currency reserve accumulation.
When the global crisis hit, a process of adjustment was eventually imposed both to
deficit and surplus countries. The current account deficits run by the US strongly contracted, due
to the combination of a large shrinkage in private investment, a huge drop in government savings,
and an increase in private savings. As a counterpart to such process, a number of new deficit
countries has emerged and have partially substituted the US and the deficit countries of Europe in
absorbing world surpluses. China is undergoing a stage of adjustment in its external balance sheet
as well. In 2010-2012, capital inflows from exports and capital flows other than FDI have slightly
decreased, while capital outflows from imports, Chinese direct investment abroad and other
capital flows have strongly increased. This has determined the shrinkage of the balance of
payments – the narrowing of both current account surpluses and net capital inflows – and thus
less room for reserve accumulation. These empirical evidences, and a significant debate at both
117
the academic and official level, suggest that the Chinese development model is currently changing
from one dominated by export-led growth, cheap labour, FDI support and government-led
reforms, to one characterized by domestic consumption-led growth, sustainable development, FDI
investment abroad and technological innovation. Overall, empirical evidences from the post-crisis
years confirm that global imbalances are a good predictor of the distribution of macroeconomic
outcome during the eventual adjustment phase. Countries with excessive current account
imbalances prior to the crisis also experienced the largest contractions in their external balance
and the sharper output reductions during the adjustment period. In the US, during the crisis a
reversal of the usual exorbitant privilege did emerge – the exorbitant duty. However, the size of
wealth transfers from the United States to the rest of the world in time of crisis have been far
lower than the usual capital gains enjoyed by the US over the last decades.
Global imbalances can have either bad consequences – they directly increase financial
risk – or bad causes – and thus they represent significant signals of dangerous features of the world
economy. A mutual relationship between global imbalances and the international crisis can be
found. Global imbalances were an important co-determinant of the crisis, which in turn has
eventually forced their adjustment. Global imbalances were not the immediate cause of the crisis,
but they created the conditions for its development. In addition, they played an important role in
spreading worldwide and further magnifying its aftermath. However, global imbalances – as
manifested in the global saving glut – could only unfold their adverse effects in connection with a
deregulated financial sector in the United States. US’ policymakers took an informed choice not to
oppose the external trends but rather to enable the United States to take full advantage of them,
regardless of the possible adverse consequences. The win-win relationship inherent in the
international monetary system described by the Bretton Woods II hypothesis entails a
corresponding structural lost-lost relationship. Debtor and surplus countries benefit from their
mutual relationship, but from the latter dangerous consequences for both arise as well. Such
structure of the international monetary system has given way, and even contributed, to the
development of a financial environment characterized by a high level of hazardousness which has
eventually fully displayed itself in the outbreak of the crisis.
118
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