Impacts of East Asian Large-Scale Trade Surplus

J.D. Han

Eco 3370 PPP#2

Idea

• Under the gold standard system, where the amount of bullion is fixed in the short-run, a country (A)with trade surplus gets inflation, and a country(B) with trade deficits gets deflation. Thus, A’s exports falls and B’s exports rises. A and B will go back to trade balance.

• Under the current international monetary system(U.S. dollars as the Key currency; Fixed FOREX system with Sterilization Policy) and , A can have trade surplus with B running trade deficits almost indefinitely.

Historically

• In the Late 18th Century-U.K. had a big trade surplus with the world-Non deflationary to other countries as U.K. invested surplus funds in the world

• 1870-1890s

The newly developing U.S. and Germany had a huge surplus

They were highly deflationary to the rest of the world as surplus was used for domestic investment

China in the 18-19th Century

• China had a huge trade surplus with European countries.

• It was deflationary as a very little fund from trade surplus went back to the world.

Post World War II

• No longer ‘Species currency system”

• Change into the Key Currency System

1970s and 1980s

• Japan had a huge Trade Surplus with U.S.

• Somewhat deflationary

• U.S. could still run deficits and print liquidity

Eventually, Japan

• Developed “Conflicted Virtue” by Ronald McKinnon

- with anticipated appreciation of Yen, the domestic interested fell to zero.

Why? In Portfolio substitution theories, i us = i japan with no risks. But with risk i us = i Japan + positive risk premium, i Japan is driven to zero.

China after 1995

• China has become the factory for U.S.

• China sends Capital back to U.S.

Key Issues of Current International Financial Flows between East Asia and U.S.

1) How did it start? By nature or by design? - J.D. Han’s short paper on the historical perspective of the U.S. Supply Chain in East

Asia

2) Domestic Macroeconomic Conditions dictates the capital flows - U.S. domestic macroeconomic conditions ( relatively Strong Domestic Investment)

dictates U.S. trade deficits; and China and East Asian ( relatively Weak Domestic Investment) happens to be the best fitting partner;

- FOREX issues are ‘red herring’ Next Powerpoint3) Still there are some Expected Problems

-Ronald McKinnon’s paper on the Conflicted Virtue of China

4) Impact of Current World Recession - Erturk’s Paper on the Changed U.S. Absorption Capacity of Chinese Capital

“Conflicted Virtue”

• The current international division of labor between China and U.S. has worked on the premise that the Chinese do not fully trust the Chinese currency (or investment in China); Domestic investment or holding Yuan is an imperfect substitute for investment in U.S. dollars.

• There is a danger of” Conflicted Virtue” as the stability of the Yuan currency increases;

If C.V. happens, then there will be Liquidity Trap in China -> Monetary policy would not work.