The Transpacific Imbalance: An East Asian Perspective

The Transpacific Imbalance:An East Asian Perspective Jong-Wha Lee Korea University and ANU Warwick J McKibbin ANU and Lowy Institute Yung Chul Park Korea University Prepared for Western Economic Association Meetings, Vancouver, 30 June 2004

Motivation • What has contributed to global current account imbalances? • What are the consequences of these imbalances? • What would be feasible policies to reduce the imbalances? We provide estimates for the effects of the proposed polices based on a multi-country intertemporal general equilibrium model- the G-cubed (Asia Pacific) Model.

Overview • Causes and Development of Global Imbalances • Implications and Policy Challenges of the Imbalances • Estimating the Effects of Adjustment Policies • Concluding Remarks

How Serious is the Transpacific Imbalance? • US current account deficits increased significantly since the 1990s. • In 2003, a deficit of $542 billion(4.9% of GDP); • Japan, China and four Asian Newly Industrialized Economies have large current account surpluses (2003). • Japan: $136 billion(3.2% of GDP), • East Asian NIEs: $87b(7.6% of GDP), • China:$30b (2.1% of GDP) • Significant bilateral trade deficit of the U.S. with East Asian economies. • In 2003, US trade deficit with 10 East Asian countries amounts to $248 billion.

What Caused the Transpacific Imbalances? • Global imbalances of saving(S) and investment(I) • The U.S. (S-I)<0 widened. • Japan and East Asian NIEs (S-I)>0 increased. • US fiscal deficits and low saving • The U.S. gross saving rates declined significantly since 2001 mainly due to loose fiscal policies. • Public saving rates dropped from 4.4% in 2000 to –1.9 % of GDP in 2003. • Federal budget balance shifted from 2.5% in FY2000 to over –4.0% in FY 2003.

What Caused the Transpacific Imbalances? • Low investment in East Asian economies • After the financial crisis of 1997, investment rates declined significantly, and have not recovered yet in East Asia. • In Japan, investment rate dropped from 28.6% in 1997 to 23.5 % of GDP in 2003. • In four East Asian NIES, investment rates dropped from 31.6% in 1997 to 22.9 % of GDP in 2003. • Both private and public investments have declined in East Asia NIES: Public investment-to-GDP rate from 9.6% in 1997 to 6.2 % of GDP in 2002.

Figure 1. Saving, Investment and Current Account The U.S., 1981-2004

Figure 2. Private and Public Saving, and Current Account The U.S., 1981-2004

Figure 3. Saving, Investment and Current Account JAPAN, 1981-2004

Figure 4. Saving, Investment and Current Account Four East Asian NIEs, 1989-2004

Implications of the Transpacific Imbalance • Theory Implies: • The huge U.S. deficits ultimately lead to (real) depreciation, thereby switching demand from imports to domestic output. • The widening of negative saving-invest gap pushes U.S. interest rates up, thereby helping the gap to diminish. • But, the imbalance has sustained: • This would be expected from theory but in addition the U.S. deficits are manageable for longer because East Asia is willing to finance them by accumulating an unlimited amount of dollar reserve assets in order to keep exchange rates undervalued.(Dooley, Folkerts-Landau, and Garber).

What Role for East Asia’s “Export-led growth” policy? • East Asia (the periphery) pegs to the US dollar (the center’s currency) -- “The Revived Bretton Woods System” • “Fear of floating” – East Asia maintains exchange rates stable vis-à-vis the US dollar. • Distort real exchange rate to keep competitiveness of export sector (but how long can this work?). • Accumulate low interest-rate reserve assets. • East Asia’s exchange rate policy is not the principle cause of the growing global imbalances. • Many East Asian countries ran large current account deficits before the crisis. • much of the increase in current account surpluses is explained by low investment demand since the crisis.

Figure 7. Real Effective Exchange Rate (China, Japan, and Korea) (Avg of 2000 = 100)

Figure 8. Real Effective Exchange Rate (Indonesia, Malaysia, Philippines, Singapore, and Thailand)

Figure 9. Real Effective Exchange Rate(Hong Kong and Taiwan)

Table 4. International Reserves of East Asia, 1999~2003$US billions Source: IMF, International Financial Statistics

Consequences of the Imbalances • Increasing pressures on East Asian economies • Reserve accumulation began to result in inflation. • Real appreciation is already occurring. • Widening gap between tradables and non-tradables. • Pegging exchange rates invites speculative capital inflows which can lead to boom and bust cycles. • Concerns about the persisting U.S. fiscal deficits. • The loose fiscal policy expects to put fiscal balance in deficits into the next decade. • Current U.S. dollar depreciation reflects that people begin to worry about the sustainability of the U.S. deficits.

What Can Be Done by East Asia? • 1. Increase exchange rate flexibility • Who will move first? No collective exchange rate policy. • Is China ready for a more flexible regime? • The bilateral trade imbalances between countries in the region add complications. • Will the exchange rate adjustment have much impact on transpacific imbalance? • 2. Expansionary aggregate demand policy • Little room for monetary expansion • Regionally concerted fiscal expansion (Eichengreen and Park, 2004). • Would it work to improve the US balance? • 3. Others • Status quo: gradual adjustments anyway occur. • Accelerated Trade liberalization

Estimating the Effects of Alternative Shocks and Policies

The G-Cubed (Asia Pacific) Model www.gcubed.com

The G-Cubed Model • Key features • Based on explicit intertemporal optimization by households and firms in each economy in a dynamic setting • Substantial sectoral dis-aggregation with macroeconomic structure • Explicit treatment of financial assets with stickiness in physical capital differentiated from flexibility of financial capital • Short run deviation from optimizing behavior due to stickiness in labor markets, myopia • Short run “New Keynesian” Model with Neoclassical steady state

G-Cubed Model • 12 sectors production in each economy • Plus a capital good producing sector • Plus a household durable production sector (I.e. housing) • Estimation of KLEM technology in production and consumption • Tracks flows of international trade at the sectoral level • Tracks flows of international capital • Distinguishes between relatively traded and non trade goods (all goods are potentially tradeable)

Economies United States Japan Australia New Zealand Canada Europe Korea Thailand Indonesia China Malaysia Singapore Taiwan Hong Kong Philippines India Oil Exporting Developing Countries Eastern Europe and the former Soviet Union Other Developing Countries

Sectors • Energy • Mining • Agriculture • Durable Manufacturing • Non-Durable Manufacturing • Services

Simulations • Sustained fall in Asian Investment • rise in equity risk premia of 2% in non Japan/non China Asia; 0.5% in Japan) • Permanent US fiscal expansion financed by debt • Rise of 4% of GDP fiscal deficit • 1% of GDP on Goods/services • 1% of GDP on labor • 2% of GDP of income tax cuts • Revaluation of Chinese Exchange Rate of 10% • Fiscal Stimulus in non-Japan Asia • 2% of GDP comprising 1% GDP goods/ services and 1% GDP on labor

Adjustment Story: Asian Investment Decline • Rise in equity risk premium implies rate of return on capital must rise above other assets • Capital stock must fall to generate the higher return • Investment declines • Portfolio holders substitute out of equities into bonds (r falls), into housing (housing prices rise) and into foreign assets (capital outflow) • Real exchange rate depreciates and GDP falls • raising exports and lowering imports • Consistent with excess savings relative to investment • Current account improves

Adjustment Story: US Fiscal Policy • Similar to Mundell-Fleming story except intertemporal overlay and asset adjustment • Higher spending/lower taxes initially raises GDP but over time GDP falls as resources are extracted from the private sector to finance the fiscal deficit • Partial Ricardian adjustment in Consumption but long term real interest rates rise to free up resources to finance the deficit • Net capital inflow which appreciates the US real exchange rate • Exports fall, imports rise

Adjustment Story: US Fiscal Policy • Investment rises initially but then falls, private saving rises but total savings falls by more than investment • US Current account deteriorates • High long term real interest rates lowers global investment improving Asian current accounts

Adjustment Story: Chinese Revaluation • Real exchange rate initially appreciates • Over time prices rise less quickly and the real exchange eventually returns to base • Chinese GDP falls relative to base by 4% in the first year • Exports less competitive but domestic slowdown reduces imports • Trade balance worsens slightly • GDP in other countries ambiguous depending on competition with China versus fall in Chinese demand from trading partners • Overall impact on US/Asia trade balances is neglible

Adjustment Story: Asian Fiscal Stimulus • Similar story to US policy except partial exchange rate targetting in some countries causes larger rises in GDP in Asia • Less impact on long term real interest rates because of economic size and less crowding out of foreign investment • Capital flows in to finance the fiscal deficit • Real exchange rate appreciation • Trade balance deteriorates

Source: G-Cubed Asia Pacific Model version 58n

Conclusions • Predominant contribution to the transpacific trade imbalance is US fiscal policy • Weak Asian investment since the 97 Crisis also important for the Asian trade surpluses but less important for the transpacific balance • US fiscal contraction and Asian fiscal expansion plus a recovery in Asian investment rates would have a significant impact on reducing each country’s overall trade position and would also reduce the Transpacific trade imbalance

Conclusions • Chinese exchange rate revaluation has significant effects on slowing China but not in changing global trade balances • The worsening in Chinese competitiveness plus weaker Chinese growth tends to offset each other in the spillover to other countries and have a minor impact on the relative saving and investment balances across the region.

Background Papers www.sensiblepolicy.com www.notwrong.com

The Transpacific Imbalance: An East Asian Perspective