Trump has misunderstood reasons for US deficit with China

Source:Global Times Published: 2018/2/18 10:01:32

US President Donald Trump has claimed numerous times that China is taking advantage of the US with unfair trade practices. The Trump administration has also taken a series of protectionist measures that have pushed the two countries to the brink of a trade war.

However, is China really taking advantage of the US? An economic analysis may suggest something different. Rates of return drive the two-way capital flows between China and the US. More importantly, such two-way capital flows can sustain permanent trade imbalances even if the current account is perfectly balanced at zero.

There are two types of capital flow: fixed capital that flows in the form of foreign direct investment (FDI), and financial capital (portfolio investment) in the form of bank deposits and short-term bonds.

Two-way capital flows go both ways instead of one way between industrial countries such as the US and less developed countries (LDCs) such as China. From 2000 to 2011, industrial countries had net financial capital inflows (including foreign reserve decumulations) averaging $498 billion per year and net FDI outflows averaging $295 billion per year. In contrast, the LDCs as a block had net FDI inflows averaging $246 billion per year and net financial capital outflows (including foreign reserve accumulations) averaging $354 billion per year.

Underdeveloped financial markets in emerging economies can explain the pattern of two-way capital flows between China and the US. China will not only have rising financial capital outflows and FDI inflows as well as the massive trade imbalance seen in recent decades, but will also have a trade surplus even in the long run. 

Due to an underdeveloped banking-credit-financial system, both households and firms in China are severely constrained in terms of their borrowing. As a result, households opt to save excessively to protect against unpredictable shocks, and firms have to rely heavily on internal cash flows to finance fixed investment. 

Since domestic savings by households cannot be effectively channelled to firms where fixed capital formation takes place, fixed capital is scarce in the production sector while savings are abundant in the household sector. 

In such a world, the rate of return from financial assets can be significantly lower than that from fixed capital. In China, for example, the real rate of return from fixed capital has consistently been over 20 percent in recent decades while the real rate of return from financial capital has been negative. Despite such an enormous gap, households in China save excessively and the bulk of their savings is in the form of bank deposits. 

This enormous arbitrage opportunity implies that financial liberalization between China and the US will trigger two-way capital flows. Because it is easier for financial capital to flow internationally than for fixed capital to be shipped abroad - due to issues such as transaction and transportation costs - the former will dominate the latter in global capital flows, resulting in short-run current account imbalances. 

In addition, because the rates of return from fixed and financial capital differ, the net income (interest) payments on the opposite capital flows do not cancel out, further contributing to global trade imbalances even in the long run. 

Therefore, the lack of an efficient financial system in China can lead to insufficient investment on the corporate side and a savings glut on the household side, resulting in high marginal productivity of capital and a low interest rate at the same time. The gap in the rate of return results in a two-way capital flow and trade imbalance in the short and long run. 

The reason for the US trade deficit is not what Trump thinks. It is not because China is playing an unfair game by not opening its financial sector or dumping its products. It is the result of the financial liberalization of China and the country's underdeveloped banking-credit-financial system, which China is working hard to improve. 

The article was compiled based on a report written by Pengfei Wang, professor of economics at the Hong Kong University of Science and Technology, Yi Wen, assistant vice president, Federal Reserve Bank of St. Louis and Zhiwei Xu, associate professor of finance at Shanghai Jiao Tong University.


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