Handbook of Safeguarding Global Financial Stability: Political, Social, Cultural, and Economic Theories and Models

Table of Contents

Cover image

Title page

Copyright

Volume 2

Section Editors for this volume

Preface

Contributors

I: Political Economy of Financial Globalization

Chapter 1. China and Financial Globalization

Introduction

A Brief History of China’s Financial Opening

China’s Current Account and Saving Behavior in Cross-Country Context

Explanations for China’s High Saving

Conclusion

See also

Acknowledgments

Glossary

Further Reading

Chapter 2. Emerging Markets Politics and Financial Institutions

Introduction

Analytical Framework

Testing the Abiad–Mody Results on a Wider Sample

Differing Influences, Across Types of Countries and Types of Reform

Conclusion

Appendix

References

Chapter 3. The Political Economy of Exchange-Rate Policy

Introduction

Economic Explanations of Exchange-Rate Policy: Important but Insufficient

Preferences: The Demand for Exchange-Rate Policy

Institutions and Exchange-Rate Policy

Conclusion

See also

Glossary

Further Reading

Chapter 4. Financial Institutions, International and Politics

Introduction

Intellectual Background

International Financial Institutions: How Much Autonomy?

International Financial Institutions: Effects

Conclusion

See also

Glossary

Further Reading

Relevant Websites

Chapter 5. Political Economy of Foreign Aid, Bilateral

Political Economy of Aid Disbursement

Political Economy of Aid Receipt

Making Good

Conclusion

References

Chapter 6. Interest Group Politics

Political Economy Models of Economic Integration

Interest Groups

Distributional Implications of Financial Globalization

The Political Economy of Financial Globalization in Authoritarian Regimes

MNCs as Actors

Conclusion

See also

Glossary

Further Reading

Chapter 7. International Conflicts

International Conflict

Civil War and Domestic Conflict

Scholarship with Implications for the Study of War and Peace

Conclusion

Further Reading

Chapter 8. The Political Economy of International Monetary Policy Coordination

Introduction

The Potential Gains from International Coordination

The Problem: Exchange Rate Externalities

Exchange Rate Coordination: Motivation and Modalities

Conclusion

See also

Glossary

Further Reading

II: Theoretical Perspectives on Financial Globalization

Chapter 9. Theoretical Perspectives, Overview

Introduction

Net Capital Flows and the Current Account

Gross Capital Flows and the Structure of International Balance Sheets

Capital Flows and Crises

Exchange Rates as Asset Prices

Financial Globalization and the Policy Environment

Conclusions

See also

References

Chapter 10. Capital Mobility and Exchange Rate Regimes

Origins and Representation of the Policy Trilemma

Dynamics of Exchange Rate Regimes in the Modern Era

Capital Mobility in the Modern Era

Evidence on the Policy Trilemma

Other Economic Effects of the Exchange Rate Regime

Conclusion

See also

Glossary

References

Chapter 11. Microstructure of Currency Markets

Introduction

Currency Trading Models

From Micro to Macro

Micro Perspectives on Exchange Rate Puzzles

Conclusion

Glossary

Further Reading

Chapter 12. Intertemporal Approach to the Current Account

Introduction

Intertemporal Theories

Empirical Relevance of the Theory and its Implications

Conclusion

See also

Glossary

Further Reading

Chapter 13. Endogenous Portfolios in International Macro Models

Introduction

A Simple Example Model

General Properties of Approximate Solutions

Mathematical Foundations

Applications

Conclusion

See also

Glossary

References

Chapter 14. Financial Contagion

Introduction

Bank Balance Sheet Adjustments as a Channel of Contagion: The International Financial Multiplier

Financial Contagion Through Interbank Linkages

Bank Runs and Self-Fulfilling International Crises

See also

Glossary

Further Reading

Relevant Websites

Chapter 15. Financial Development and Global Imbalances

Introduction

Financial Globalization and Financial Underdevelopment: Stylized Facts

Explaining Global Imbalances: Financial Globalization with Financial Underdevelopment

Consequences of Global Imbalances

Global Imbalances with Cross-Country Heterogeneity in Growth

Conclusions

References

Chapter 16. Foreign Currency Debt

Introduction

Risks of Foreign Currency Debt

Reasons for Holding Foreign Currency Debt

Development of Local Bond Markets

Conclusion

References

Chapter 17. International Trade and International Capital Flows

Introduction

Conclusion

Glossary

References

Chapter 18. International Macro-Finance

Introduction

The Workhorse Model

Next Steps

See also

References

Chapter 19. Monetary Policy and Capital Mobility

Introduction

Growth in International Capital Mobility and Monetary Policy

Arguments for Improved Monetary Policy Under Increased Capital Mobility

Theoretical Arguments for Reduced Monetary Policy Quality

Empirical Evidence

Conclusion

See also

References

Chapter 20. Theory of Sovereign Debt and Default

Introduction

Why Do Countries Repay Their Debts?

Why Do Countries Borrow So Much?

Policy and Welfare

Conclusion

See also

Further Reading

Chapter 21. Tax Systems and Capital Mobility

Introduction: Implications of Globalization for Tax Systems

National Taxation and International Mobility

International Tax Coordination

Summary and Conclusions

Further Reading

Chapter 22. Trade Costs and Home Bias

Introduction

The Equity and Consumption Home Biases: Facts and Figures

Why Investors Would Hold Different Equity Portfolios?

Home Bias in Equities and the Hedging of Real Exchange Rate Risk

Home Bias in Equities and the Hedging of Nontradable Risk

Trade Costs and Portfolio Home Bias: Alternative Stories

Conclusion

Acknowledgments

References

Chapter 23. Explaining Deviations from Uncovered Interest Rate Parity

Introduction

Risk Premium with Representative Investors

Limited Participation

Deviations from Rational Expectations

Conclusion

References

Chapter 24. Valuation Effects, Capital Flows and International Adjustment

Introduction

Financial Globalization and Valuation Effects

International Portfolio Choice and Adjustment in Theory

Interpretation of the External Accounts

Concluding Remarks

See also

Further Reading

III: Safeguarding Global Financial Stability

Chapter 25. Safeguarding Global Financial Stability, Overview

Financial Stability

Establishing and Maintaining Financial Stability

Crisis Management and Avoidance

Global Approaches

Other Issues

See also

References

Chapter 26. Resolution of Banking Crises

Introduction

The 2007–09 Global Crisis: A Synopsis

Which Countries Had a Systemic Banking Crisis in 2007–09?

Policy Responses in the 2007–09 Crises: What Is New?

How Costly Are the 2007–09 Systemic Banking Crises?

Concluding Remarks

Appendix

Acknowledgment

Glossary

References

Chapter 27. Advantages and Drawbacks of Bonus Payments in the Financial Sector

Introduction

Principal–Agent Theory: Why Bonuses may be Beneficial

Why Ideal Contracts may well be Unavailable

Implications for Contracts in the Financial Sector

Assessing the Case for Profit-Related Pay

Are Financial Sector Bonuses Actually Deserved?

Arguments Against Restricting Financial Sector Bonuses

Some Technical Difficulties

Some Specific Practical Problems with Bonuses

Implementation

Concluding Comments

References

Chapter 28. Central Banks Role in Financial Stability

Introduction

The Broader Monetary and Financial Framework

Financial Stability: National or International?

Financial Stability Framework

Financial Stability Functions of Central Banks

Conclusion

References

Chapter 29. Organization, Supervision and Resolution of Cross-border Banking

Introduction

The Nordea Case

Subsidiary and Branch Organizations in Theory and Practice

Organization of Supervision and Crisis Management: Can National Responsibility Be Effective?

Conclusions: Need for Reform of the Architecture for Supervision and Crisis Management

References

Chapter 30. Dynamic Provisioning to Reduce Procyclicality in Spain

Introduction

The Housing Boom and Bust in Spain

The Introduction of Dynamic Provisions in Spain

Comparison with Other Countries: Peru and Colombia

Conclusions

See also

Glossary

Further Reading

Chapter 31. Varieties of European Crises

Introduction

A Brief Overview of the Varieties of Financial Crises with Illustrations from Europe

The Crises of the European Monetary System 1992–93 and Nordic Banking Crises

Europe in the Global Financial Crisis 2007–09

Concluding Remarks; Lessons from European Crises

See also

References

Chapter 32. The Financial Sector Assessment Program

Origins of the International Monetary Fund/World Bank Financial Sector Assessment Program

The Objectives of the FSAP

The Program’s First Decade: Milestones and Country Participation

Areas of Assessment

Standards Assessments in the FSAP

The Conduct of an Assessment

Further Reading

Relevant Websites

Chapter 33. Financial Sector Forum/Board

Establishment of the Financial Stability Forum

Initial Work

First Decade

From Financial Stability Forum to Financial Stability Board

Recent Developments

Evaluation of Role of FSF

Chapter 34. Financial Stability and Inflation Targeting

Introduction

The Separation of Monetary and Financial Policy

Does Price Stability Promote Financial Stability?

Does Price Stability Guarantee Financial Stability?

Does IT Constrain the Response to Financial Crises?

New Directions Following the 2007–09 Crisis

See also

Further Reading

Chapter 35. Financial Supervision in the EU

Introduction

Prudential Supervision

Conduct of Business

Supervisory Structures

New European Financial Supervisory Framework

Conclusions

References

Chapter 36. Groups: G-5, G-7/8, G-10, G-20, and Others

Introduction

A Short History of ‘G’ Group Cooperation

Existing ‘G’ Group Scholarship

Why Do Governments Participate in ‘G’ Groups?

‘G’ Group Functions

Conclusions: The G20 and Political Conflict

See also

Glossary

Further Reading

Relevant Websites

Chapter 37. Market Structures and Market Abuse

Introduction

Regulatory Rationale of Market Abuse Laws

Market Developments: Technology and Regulation

Advanced Trading Techniques and Market Abuse

Reforming the EU MAD

Conclusion

Glossary

Further Reading

Chapter 38. Development and Evolution of International Financial Architecture

Introduction

Metallic Standards

What Did Gold Provide?

Interwar

War and Redesign

Bretton Woods

Post-Bretton Woods

Conclusion

See also

Glossary

Further Reading

Chapter 39. On the Role of the Basel Committee, the Basel Rules, and Banks’ Incentives

Introduction

The Evolving Role of the Basel Committee on Banking Supervision

Basel Capital Requirements as Essential but not Sufficient Regulatory Tool

From Basel I to Basel III: What Has Changed?

What are the Unresolved Flaws of Basel Regulations?

Basel Regulation, Incentives, and Role of Pillars 2 and 3

References

Chapter 40. International Monetary Fund

Introduction

The Fund in June 2011

Criticisms of the IMF

Conclusions and Recommendations

See also

Acknowledgments

Further Reading

Relevant Website

Chapter 41. Innovations in Lender of Last Resort Policy in Europe

Introduction

Underlying Conceptual Issues

LoLR in the Euro Area under ‘Normal’ Market Conditions

LoLR in the Euro Area during ‘Exceptional Times’

Concluding Remarks

See also

References

Chapter 42. Micro and Macro Prudential Regulation

What Is Macroprudential Regulation?

Macroprudential Regulation and the Cycle

Valuation and Mark-to-Funding Accounting

Macroprudential Regulation Beyond the Cycle

Host- and Home-Country Regulation

Conclusion

Glossary

References

Chapter 43. Role and Scope of Regulation and Supervision

Key Issues

Instruments in a Regulatory Regime

Reducing the Probability of Failures

Minimizing the Cost of Bank Failures

Summary of the Argument

Further Reading

Chapter 44. Independence and Accountability of Regulatory Agencies

Introduction

Independence and Accountability in Theory

Independence and Accountability in Practice

References

Chapter 45. Institutional Structures of Regulation

Introduction

Institutional Structures of Supervision

The Role of the Central Bank

References

Chapter 46. Organizations of International Co-operation in Standard-Setting and Regulation

International Financial Regulation

International Financial Standards and Standard-Setting Organizations

Policy Direction

Coordination

Key Standards for Sound Financial Systems

Process of Standard Setting

International Standard-Setting Organizations

IFIs and Other Formal International Organizations

International Financial Organizations

Implementation and Monitoring

References

Chapter 47. Prevention of Systemic Crises

How the Financial System should be Structured

How the Financial System should be Regulated

How Prudence can be Encouraged

How Crisis Resolution Tools can Contribute to Prevention

See also

Glossary

Further Reading

Chapter 48. Lines of Defense Against Systemic Crises: Resolution

International Efforts to Promote Effective Resolution Regimes

FSB Policy Measures to Reduce Moral Hazard Risks

A New International Standard for Resolution Regimes

Building Cross-Border Cooperation

Corporate Insolvency

National and Regional Initiatives

Objectives of Resolution

A Special Resolution Regime for Banks and Other Financial Institutions

Resolution Regimes as Key Component of the Financial Safety Net

Features of a Special Resolution Regime: The ‘FSB Key Attributes’

Conclusion

Further Reading

Index

Copyright

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Volume 2

Editor-in-Chief

Gerard Caprio Jr.

Williams College, Williamstown, MA, USA

Associate Editors

Thorsten Beck

CentER and European Banking Center, Tilburg University, The Netherlands and CEPR, London, UK

Charles W. Calomiris

Columbia University, New York, NY, USA

Takeo Hoshi

School of International Relations and Pacific Studies, University of California, San Diego, CA, USA

Peter J. Montiel

Williams College, Williamstown, MA, USA

Garry J. Schinasi

Independent Advisor, Global Financial Stability, Washington, DC, USA

Section Editors for this volume

Section Editors for this volume

Philippe Bacchetta

University of Lausanne, Lausanne, Switzerland

James R. Barth

Auburn University, Auburn, AL, USA, and Milken Institute, Los Angeles, CA, USA

Takeo Hoshi

School of International Relations and Pacific Studies, University of California, San Diego, CA, USA

Philip R. Lane

Trinity College Dublin, Dublin, Ireland

David G. Mayes

University of Auckland, Auckland, New Zealand

Atif R. Mian

Haas School of Business, University of California at Berkeley, Berkeley, CA, USA

Michael Taylor

Adviser to the Governor, Central Bank of Bahrain, Manama, Bahrain

Section Editors for related volumes

Douglas W. Arner

University of Hong Kong, Pokfulam, Hong Kong, SAR, China

Charles W. Calomiris

Columbia University, New York, NY, USA

Stijn Claessens

International Monetary Fund, Washington DC, USA, University of Amsterdam, Amsterdam, The Netherlands, and CEPR, London, UK

Larry Neal

University of Illinois at Urbana-Champaign, Urbana, IL, USA

Sergio L. Schmukler

World Bank, Washington, DC, USA

Nicolas Veron

Bruegel, Brussels, Belgium

Peterson Institute for International Economics, Washington, DC, USA

Preface

Although finance has been a cross-border business for centuries, there are many senses in which the world is becoming more globalized financially. To be sure, early banks carried out transactions to settle imbalances at international trade fairs in the Middle Ages, but the vast swath of society at that time lived untouched by or unconcerned with the financial world outside their village and certainly outside their region. Their world abounded with risks, yet these risks were largely of the type from which their ability to achieve any kind of protection was limited. Indeed, risk was a term that if understood at all would have very different connotations than it does today. Probabilistic thinking was not yet known, and fate or ‘God’s will’ was the more operative expression.

Finance, even in basic settings, performs the same functions throughout history as those identified by Levine (1997): mobilize savings, allocate resources, monitor investments, provide payments, and mitigate risk.¹ However, both the demand for and the ability of financial systems to provide these services have expanded and evolved in countless directions. Just as money long ago ceased to entail the burden of transporting precious metals (notwithstanding the desire of Congressman Ron Paul, a US presidential candidate as of this writing, to do away with central banks and return to a world of money backed by gold), more recently even international payments are made by electronic transfer. Residents of the world can now travel to other countries carrying only a piece of plastic to make payments, and likely soon will be dispensing with plastic, using a chip built into their cell phones. Many workers in middle-income countries today, and most in higher income economies, have bank accounts or more likely mutual or pension funds with investments outside their home country, though some may not be well aware of their exposure. Just as pensions deal with a risk previously unrecognized – the period after the working stage of life used to be death, and later in time the exceptionally brief interlude of care was provided by families – many risks covered by financial instruments today are relatively recent in being perceived, let alone addressed by finance.

The many advances in financial services come with a cost, including the cost of crises. Certainly, crises have been important as long as modern banks have existed – from the failure of banks in northern Italy (including the Ricciardi, the Bardi, and the Peruzzi banks) to the ongoing Euro crisis and the impairment of bank balance sheets that of this writing still is officially minimized. The persistence of crises – which Kindleberger once dubbed ‘A Hardy Perennial’ – might seem puzzling. Why do societies not learn and protect themselves and/or regulate the financial system better? The answer of course is that finance arises due to information asymmetries, without which there would not only be no crises but also no return for financial intermediaries.

Notwithstanding these many constants, the shape of finance has changed markedly in recent decades since the era of extensive domestic and international controls in the aftermath of World War II, when much of the world lived in a period in which the returns on many assets were controlled, instruments not allowed, credit guidance was directly or subtly provided by government, and, in socialist economies, mandated almost entirely by the hand of the state. Now for the first time in history, the residents of virtually all countries can participate in the global financial system, though many, especially in the lowest income countries, remain locally based. But controls have been lifted, capital flows freely across many borders, and financial innovations occur at a rapid pace, even if not all of these innovations contribute to society’s welfare. And efforts to control the financial system understandably advance as the industry itself changes.

It is into this situation in the development of global finance that the present effort comes. Three volumes – the Handbook of Key Global Financial Markets, Institutions, and Infrastructure; the Handbook of Safeguarding Global Financial Stability: Political, Social, Cultural, and Economic Theories and Models; and The Evidence and Impact of Financial Globalization – have been put together online and in print to advance our understanding of the origins, requirements, and consequences of financial globalization. The chapters herein share a common overarching goal: to describe the many issues related to financial globalization. The first volume looks at the historical roots of financial globalization, as this is not the first time financial systems have trod this path, and likely will not be the last. Given the technology of today, it then turns to look at the ‘plumbing’ that underlies a healthy financial system, both at the national and global level, including that which supports the ever-changing panoply of new instruments. Financial infrastructure shapes financial systems as surely as any regulator. Thus, some developing countries are at present just seeing the birth of a private bond market, which often is the last part of the system to develop as a result of the demands that it places on the legal system and on information.

The second volume examines the political economy of finance. Since its inception, finance has been intimately linked with government. Just as goldsmiths and other early bankers were discovering that not all depositors demanded their money back every day, so that some funds could be profitably deployed, kings were desperately seeking funding for soaring armament expenditures, and a relationship that continues to this day was born. Once the sovereign’s security was assured, other governmental functions needed finance, as did the many projects, useful and not, of the sovereign’s supporters. Bankers’ financial clout quickly translated to political power, and the difficulty of getting financial regulation that works, in addition to being linked to the difficulty of the job, has also been linked to the influence of the industry. Thus, the volume also turns to a discussion of what is meant by financial stability, of attempts to safeguard the stability of the global financial system, and of the many international bodies that are involved in the effort and how they might contribute to this goal. Finally, this volume also looks at how various theories of financial globalization evolved with the developments in the markets. Interestingly, debates on flexible versus fixed exchange rates during the 1960s completely missed the story of what happened once the Bretton Woods system ended.² As tumultuous as the ‘real world’ has been with more integrated financial markets and flexible exchange rates, one senses that the theoretical literature is evolving significantly as well.

Last, but certainly not least, is the final volume that looks at the expanding literature on empirical research regarding the forces behind and the impact of financial globalization, how it has affected policies, and the crises associated with globalized finance, which are transmitted through many channels. The scope of the issues covered in this volume alone testifies to the complexity of the phenomenon.

In this investigation of financial globalization, it is worthwhile to remember that progress has not been linear. It was less than 90 years ago that Keynes could write that

The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and reasonably expect their early delivery upon his doorstep; he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world, and share, without exertion or even trouble, in their prospective fruits and advantages; or he could decide to couple the security of his fortunes with the good faith of the townspeople of any substantial municipality in any continent that fancy or information might recommend. He could secure forthwith, if he wished it, cheap and comfortable means of transit to any country or climate without passport or other formality, could dispatch his servant to the neighboring office of a bank for such supply of the precious metals as might seem convenient, and could then proceed abroad to foreign quarters, without knowledge of their religion, language, or customs, bearing coined wealth upon his person, and would consider himself greatly aggrieved and much surprised at the least interference. But, most important of all, he regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement, and any deviation from it as aberrant, scandalous, and avoidable.³

Keynes’ last sentence ranks among the most memorable in financial history, both because of how accurately it described the past and how little it applied to the ensuing decades. World War I of course interrupted the state of affairs that he described, but as we now know was only the first shock to disrupt the system. Caution in forecasting financial globalization therefore seems wise. Following the crisis that began in 2007, with the calls for a Tobin-type tax, the possibility as of early 2012 that one or more members will exit from the Euro, and even the fears of a new Middle East war, few would venture predicting that an immediate further deepening for financial globalization is inevitable. Still, the technology that was so evident in the ‘Arab Spring,’ namely cheap and easy communications, makes it hard to see how the globalization genie can be put back in the bottle. Then again, that is why true ‘shocks’ deserve their appellation! Whatever the immediate outcome, this stocktaking is timely.

This project was a labor of love for a great set of professionals who worked tirelessly on this effort: Thorsten Beck, Charles Calomiris, Takeo Hoshi, Peter Montiel, and Garry Schinasi as associate editors were instrumental in early decisions on the shape of the effort and on desired content, as well as of great value in finding section editors and authors. The section editors – Thorsten, Charlie, and Takeo taking on this additional burden, along with Douglas Arner, Philippe Bacchetta, James Barth, Stijn Claessens, Philip Lane, David Mayes, Atif Mian, Larry Neal, Sergio Schmukler, Michael Taylor, and Nicholas Veron – were instrumental in finding the best authors for the targeted chapters and along with those wearing the associate editor hat in reviewing the chapters. Of course, the effort would not exist without the labors of the individual authors, who worked to bring the reader this unparalleled effort. A huge debt of thanks is owed them, both by me as editor and on behalf of all those using this resource in the future. I certainly learned much and was happy to see that so many busy, first-rate professionals were willing to devote the time and effort to this project. Like globalized finance, immense intellectual efforts such as the present one involve much debt! Unlike some financial debt, however, this one is a debt that will keep on paying.

Gerard Caprio Jr.

William Brough Professor of Economics, Williams College

February, 2012

¹Levine, R., 1997. Financial development and economic growth: views and agenda. Journal of Economic Literature 35 (2), 688–726.

²A discussion with Bob Aliber, David Love, Peter Montiel, and Ted Truman was useful in this regard.

³Keynes, J.M., 1920. The Economic Consequences of the Peace, Harcourt, Brace and Howe, New York, pp 11–12.

Contributors

A. Abiad, International Monetary Fund, Washington, DC, USA

K. Alexander, University of Zurich, Zurich, Switzerland, University of Cambridge, Cambridge, UK

R. Ayadi, Centre for European Policy Studies, Brussels, Belgium

P. Angkinand, Milken Institute, Santa Monica, CA, USA

D.W. Arner, University of Hong Kong, Hong Kong, SAR, China

P. Bacchetta, University of Lausanne, Lausanne, Switzerland, CEPR, London, UK

A. Baker, Queen’s University Belfast, Belfast, Northern Ireland, UK

J.R. Barth, Auburn University, Auburn, AL, USA, Milken Institute, Santa Monica, CA, USA, Wharton Financial Institutions Center, Philadelphia, PA, USA

P.R. Bergin, University of California at Davis, Davis, CA, USA

J.L. Broz, University of California, San Diego, CA, USA

F. Capie, City University, London, UK

M. Chamon, International Monetary Fund, Washington, DC, USA

M.D. Chinn, Robert M. La Follette School of Public Affairs, Department of Economics and NBER, Madison, WI, USA

N. Coeurdacier, Sciences Po and CEPR, Paris, France

M.B. Devereux, University of British Columbia, Vancouver, BC, Canada

M.P. Devereux, Oxford University Centre for Business Taxation, Oxford, UK

M.D.D. Evans, Georgetown University, Washington, DC, USA

S. Fernández de Lis, BBVA, Madrid, Spain

J.A. Frieden, Harvard University, Cambridge, MA, USA

C. Fuest, Oxford University Centre for Business Taxation, Oxford, UK

A. Garcia-Herrero, BBVA, Hong Kong, Hong Kong, SAR, China

G.G.H. Garcia, Alexandria, VA, USA

E. Gartzke, University of California at San Diego, CA, USA

J.M. González-Páramo, European Central Bank, Frankfurt am Main, Germany

E. Hüpkes, Swiss Federal Banking Commission, Switzerland

H. Ito, Portland State University, Portland, OR, USA

K. Jin, London School of Economics, London, UK

Z. Kelly, US Department of Defence, PA, USA

M.W. Klein, Tufts University, Medford, MA, USA

R. Kollmann, ECARES, Université Libre de Bruxelles, Brussels, Belgium, Université Paris-Est, Paris, France, Centre for Economic Policy Research, London, UK

K.N. Kuttner, Williams College, Williamstown, MA, USA

L. Laeven, Research Department of the International Monetary Fund, CEPR, Westminster, England, UK

P.R. Lane, CEPR, London, UK, Trinity College Dublin, Dublin, Ireland

K. Langdon, International Monetary Fund, Washington DC, USA

D.T. Llewellyn, Loughborough University, Loughborough, Leics, UK, CASS Business School, London, UK, Vienna University of Economics and Business, Vienna, Austria

E.J. Malesky, Duke University, Durham, NC, USA

F. Malherbe, London Business School, London, UK

S. Marcus, Financial Sector Assessment Program, Wakefield, RI, USA

L.L. Martin, University of Wisconsin-Madison, Madison, WI, USA

D.G. Mayes, University of Auckland, Auckland, New Zealand

E.G. Mendoza, University of Maryland, College Park, MD, USA, National Bureau of Economic Research (NBER), Cambridge, MA, USA

A. Pavlova, London Business School and CEPR, London, UK

A.D. Persaud, Gresham College, London, UK, London Business School, London, UK

L. Promisel, Economic Consultant, Washington DC, USA

V. Quadrini, University of Southern California, Los Angeles, CA, USA, Centre for Economic Policy Research (CEPR), London, UK, National Bureau of Economic Research (NBER), Cambridge, MA, USA

R. Rigobon, Sloan School of Management, MIT and NBER, Cambridge, MA, USA

D. Schoenmaker, Duisenberg School of Finance, Amsterdam, The Netherlands

P. Sinclair, University of Birmingham, Birmingham, UK

M.M. Spiegel, Federal Reserve Bank of San Francisco, San Francisco, CA, USA

D. Steinberg, University of Oregon, Eugene, OR, USA

A. Sutherland, University of St Andrews, Fife, UK

M. Taylor, Manama, Bahrain

M.W. Taylor, Bank of International Settlements

C. Tille, Graduate Institute of International and Development Studies and CEPR, Genève, Switzerland

F. Valencia, Research Department of the International Monetary Fund, Westminster, England, UK

S. Walter, University of Heidelberg, Heidelberg, Germany

E. Werker, Harvard Business School, Boston, MA, USA

C. Wihlborg, Chapman University, Orange, CA, USA

T.D. Willett, Claremont Graduate University and Claremont McKenna College, Claremont, CA, USA

Mark L.J. Wright, Federal Reserve Bank of Chicago, Chicago, IL, USA, University of California, Los Angeles, CA, USA, National Bureau of Economic Research, Cambridge, MA, USA

I

Political Economy of Financial Globalization

Chapter 1 China and Financial Globalization

Chapter 2 Emerging Markets Politics and Financial Institutions

Chapter 3 The Political Economy of Exchange-Rate Policy

Chapter 4 Financial Institutions, International and Politics

Chapter 5 Political Economy of Foreign Aid, Bilateral

Chapter 6 Interest Group Politics

Chapter 7 International Conflicts

Chapter 8 The Political Economy of International Monetary Policy Coordination

Chapter 1

China and Financial Globalization

M.D. Chinn* and H. Ito†

*Robert M. La Follette School of Public Affairs, Department of Economics and NBER, Madison, WI, USA

†Portland State University, Portland, OR, USA

Outline

Introduction

A Brief History of China’s Financial Opening

China’s Current Account and Saving Behavior in Cross-Country Context

Explanations for China’s High Saving

Financial Development and Corporate Finance in China

Household Behavior

Government Saving

Financial Globalization and China’s High Saving

Conclusion

Acknowledgments

Glossary

Further Reading

Introduction

China’s impact on the world economy has grown substantially over the past two decades. Attitudes toward the consequences of this development can, at best, be described as ambivalent. Some economists, notably the previous and current chairmen of the Federal Reserve, have argued that China is partially responsible for the crisis; its excess savings – that is, a current account surplus at 11% of gross domestic product (GDP) as of 2007 (Figure 1.1) – fed the profligacy of several industrialized countries, most notably the United States and the United Kingdom. These ‘global imbalances,’ they argue, gave rise to asset bubbles that eventually burst and led to the crisis.

Figure 1.1 China’s current account, financial account, and international reserves holding.

Source: CEIC, World Development Indicators (WDI).

Now, the question is how China’s current account surplus balances will evolve, as financial globalization proceeds. How does China’s access to global financial markets interact with its underdeveloped financial markets? Would opening up the Chinese capital account lead to a much trajectory?

In order to answer those questions, we review the development of external financial policies and cross-border capital flows of China. Second, we survey empirical findings of the determinants of current account balances and national saving in a cross-country context so as to identify how much portion of China’s current accounts and national saving are unexplainable with cross-country variations. Third, we provide descriptive explanations for China’s uniquely high saving rates. Last, we provide some concluding thoughts regarding China’s saving behavior and financial integration with the rest of the world.

A Brief History of China’s Financial Opening

Since 1978, the Chinese government has very gradually liberalized product markets. Liberalization policies usually start with a limited scope; the policy implementation is often targeted to carefully chosen geographical areas, and narrowly restricted to strictly defined subjects. Only when they yield convincing success does the government expand the scope of coverage and finally make it into a national policy.

Financial liberalization has also followed the same pattern. It started in 1980 when the government created the Special Economic Zones (SEZs) in four southern coastal cities and provided foreign firms in the cities (that were allowed to exist only in the form of joint ventures with local firms) with exemptions from the central planning and other special treatments including exemptions from corporate income tax and other generous tax incentives. Since then, there have been three waves of financial liberalization policies. In 1984, the experiments of the SEZs were expanded to 14 coastal cities, which led to a 98% increase in inward foreign direct investment (FDI). In 1992, when Deng Xiaoping made it clear that the country will pursue market-oriented economy (or ‘socialism with Chinese characteristics’ in his words) during his famous ‘Southern Tour,’ the government implemented further liberalization policies, which led to a surge in inward FDI in 1992 and 1993. The last wave, which is still underway, came when China joined the World Trade Organization (WTO) in 2001. In doing so, China committed to liberalize its financial markets. In this wave, FDI flows continued to be a dominant form of capital flows for the country. Only in the mid-2000s, in response to demands by foreign governments, and also in an attempt to manage an overheating economy, did the government gradually begin liberalizing other types of cross-border capital flows, such as portfolio flows and banking lending. Nevertheless, as of the beginning of 2011, the progress has been quite limited.

The last two waves can be observed in Figure 1.2(a), which depicts the evolution of capital inflows to and outflows from China. In 1993, the amount of capital inflows increases dramatically, followed by an increase in capital outflows by a similar magnitude in the late 1990s. Figure 1.2(b)–1.2(d) highlight the fact that the biggest component of the increase in capital inflows was associated with FDI flows, which have been the main form of capital inflows ever since financial opening in the early 1990s. Both inflows and outflows of ‘other’ type of investment, which is comprised mainly of bank lending, became active after 2005 while portfolio outflows (which includes both equity and debt securities). These developments reflect the authorities’ efforts to cool down the then overheating economy and lessen the appreciation pressure on the exchange rate. The global financial crisis of 2008–2009 caused a significant drop in the outflows of portfolio investment and bank lending, both of which had just experienced a significant expansion in the preceding year. The crisis has more negatively affected FDI and bank lending inflows than portfolio investment inflows.

Figure 1.2 (a) China’s capital inflows and outflows. (b) China’s foreign direct investment inflows and outflows. (c) China’s portfolio investment inflows and outflows. (d) China’s ‘other’ investment inflows and outflows.

Source: CEIC, IMF.

In contrast to the present situation, at the earlier stage of postliberalization development, the primary motive for inviting FDI inflows was to increase accessibility to the then scarce foreign exchange. As of 1980, China held only $10 billion, or 5% of its GDP, of international reserves, a stark contrast to $2.5 trillion, or 49% of GDP, as of the end of 2009. FDI is typically perceived to be the most stable source of external financing compared to the other types of flows. Furthermore, the main motive for the Chinese government to focus on encouraging inward FDI in earlier years was to import corporate governance and other know-how for management and, in later years, banking practices. The relative stability of FDI inflows was much appreciated when other Asian economies with liberalized markets for portfolio investment were more directly exposed to the Asian crisis of 1997–1998. In fact, many agree that China’s tight controls over portfolio flows shielded the economy from contagious speculative attacks on other Asian currencies at the time of the crisis. This experience seems to have convinced Chinese policy makers that they need to be careful about removing restrictions on other forms of capital flows than FDI. As we just saw, Chinese authorities started relaxing restrictions first on capital inflows and later on outflows when the Chinese economy started overheating and receiving criticism as a big contributor to the global imbalances only in the mid-to-late 2000s.

Although it has made significant progress toward more open cross-border financial transactions, China still lags behind other major economies including developing ones. While it is extremely difficult to compare the extent of financial openness, or that of capital controls, across countries, there are roughly two ways of measuring it in a cross-country context. One way is to look into the extensity and intensity of regulatory controls on cross-border capital transactions. Such a de jure approach usually uses information from the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER). The other approach is to construct a de facto measure of financial openness. Here, there are several approaches. One is to examine interest differentials, and another is to examine quantities.

Whether we use de jure or de facto measures of financial openness, it is clear that China is a laggard in terms of its openness to cross-border capital transactions. While many emerging market economies removed or loosened regulatory restrictions on capital flows in the 1990s as shown in Figure 1.3, in terms of de jure financial openness, China has not made progress since the early 1990s. It must be noted that de jure measures fail to fully capture the complexity of real-world capital controls.

Figure 1.3 De jure financial openness – China, IDC, LDC, and EMG.

Reproduced from Chinn, M.D., Ito, H., 2008. A new measure of financial openness. Journal of Comparative Policy Analysis 10(3), 309–322 and updates.

One de facto measure involves a direct measure of gaps in interest rates. In principle, one would want to examine the two measures: (i) the domestic–foreign interest rates adjusted for expected exchange rate changes (or deviations from uncovered interest parity), and (ii) the domestic–foreign interest rates adjusted for the forward discount (or deviations from covered interest parity). As expected exchange rate changes are not directly observable, the first measure is hard to examine. A recent study finds that the deviations from uncovered interest parity between the United States and China, when the rational expectations are being imposed, declined over the 1996–2001 period. The development of a nondeliverable forward (NDF) market for the Chinese yuan has provided an alternative measure of expected depreciation. Another study which uses this alternative measure, on the other hand, finds no evidence of declining interest differentials in a sample over the 1997–2005 period while allowing for a structural break in 2001, and concludes that capital controls continue to bind. Since onshore rates are higher than offshore, the controls essentially prevent capital from flowing out.

Figure 1.4 shows the 1-month covered interest differential (using offshore NDF rates), calculated using Chibor and Libor. The evidence is, if anything, stronger for binding capital controls, in the post-2005 period, with the exception of a few months right after the depegging of the yuan in July 2005. The late 2008 decrease in the differential is attributable to distortions in Libor associated with the global financial crisis.

Figure 1.4 ‘Covered’ 1-month interest differential, annualized.

Reproduced from Cheung, Y.-W, Qian, X., 2010. Capital flight: China’s experience. Review of Development Economics 14 (2), 227–247.

In Figure 1.5(a), we examine the implications of using a quantity-based measure, namely the components of the international investment position normalized by GDP – Lane and Milesi-Ferretti’s (2007) measure of de facto financial openness that is calculated as the sum of total stocks of external assets and liabilities as a ratio to GDP. It appears that China has been catching up with other developing countries since the mid-2000s. Based on Figure 1.5(b)–1.5(d), most of the catch-up is mainly driven by a rapid growth in the stock of portfolio investment (which does not include debt securities in this measure). Interestingly, the markets for debt securities have not shown any progress in terms of increasing openness toward international transactions (Figure 1.5(d)).

Figure 1.5 (a) De facto financial openness – overall. (b) De facto financial openness – FDI. (c) De facto financial openness – portfolio investment. (d) De facto financial openness – debt equity investment.

Reproduced from Lane, P.R., Milesi-Ferretti, G.M., 2007. The external wealth of nations mark II: revised and extended estimates foreign assets and liabilities, 1970–2004, Journal of International Economics, 73 (2), 223–250 and updates.

Although most researchers agree that encouraging mainly FDI inflows has helped the Chinese economy to achieve impressive economic growth, this approach to financial globalization did not come without cost. First, its asymmetrical approach to financial liberalization toward inflows and outflows of capital has made the country prone to experience surpluses in both current and financial accounts, resulting in a massive buildup of international reserves. Second, FDI inflows have also reinforced the government’s efforts to focus on industrialization through strengthening the manufacturing, capital-intensive sectors. As a result, the economy has had the tendency to experience overcapacity, which contributed to expanding exports and exacerbating current account imbalances. Third, the excessive focus on industry has also resulted in excessive capital intensity, driving down the share of national income going to labor. Many researchers have pointed out that labor income has been declining in the last decade, pushing down disposable income. Hence, the distorted industrial structure has raised savings in both the corporate and household sectors.

Thus, the unique development of financial liberalization in China has contributed to the rise of the global imbalances. To more closely examine the impact of financial globalization, we look at how saving and investment behavior has been influenced by these policies. We first investigate saving and investment determination in a cross-country context in the next section to identify common denominators of the saving and investment behavior across the countries. Once we identify the China-specific portion of current account and national saving behavior, we then focus on the peculiarities of China’s saving behavior in the following section.

China’s Current Account and Saving Behavior in Cross-Country Context

Estimating a simple empirical model of current account balances and national saving can be an effective way of identifying the commonalities and peculiarities of China’s saving behavior. Here, we discuss results from an empirical exercise based on several recent empirical studies and conducted for 23 industrial and 86 developing countries over the period of 1970–2008 to estimate the determinants of the current account balances, national saving, and investment.

In this exercise, current account balances, national saving, and investment (all expressed as a share of GDP) are individually regressed against the same set of explanatory variables, which are selected based on the literature. The vector of explanatory variables includes budget balances (as a share of GDP); private credit creation (PCGDP) as a measure of financial development; the Chinn–Ito measure of financial openness; a measure of legal/institutional development; net foreign assets as a ratio to GDP; relative income (to the United States); its quadratic term; relative dependency ratios on young and old population; terms of trade volatility; output growth rates; trade openness (= exports + imports/GDP); dummies for oil-exporting countries; and time fixed effects. The ordinary least squares estimation with heteroskedasticity-consistent standard errors is applied to the panels of nonoverlapping 5-year averages of the deviations from their GDP-weighted world means of each of the variables.

Most of the variables are found to behave consistently with what has been found in the literature. Among the variables of our interest, the estimation yielded a result consistent with the hypothesis that countries with more developed financial markets should have weaker currents accounts. The estimation also identified significant interactions between capital account openness, financial development, and legal development. More specifically, emerging market economies with better-developed financial markets and open capital accounts are found to have weaker current account balances, as if they are on the receiving end of inflows (or experience the least tendency for capital to flow out). Consistently with the saving glut hypothesis, further financial deepening coupled with higher levels of legal development would worsen current account balances.

When the model is estimated for national saving and investment separately, it is found that government budget deficits affect primarily national saving. Given that the Ricardian hypothesis predicts the estimated coefficient of budget balances to be zero, any change in public saving would be offset by the exact same change but with the opposite sign in private saving – this finding can be interpreted as evidence that there is some non-Ricardian effect of deficit spending. It is also found that dependency ratios affect both savings and investment in the way consistent with the lifetime income hypothesis. As the saving glut proponents argue, further financial development would lessen the need for precautionary saving. If a country is equipped with better-developed legal systems, the negative impact of financial development on national saving can be even larger. Financial development has a more consistent impact on investment than saving (something that would not be obvious a priori).

However, one must be careful about this sort of exercise especially if it is intended to examine the factors that led to the unique situation of the global imbalances on the eve of the crisis. Because the global crisis can be interpreted as a large-scale correction of the imbalances, some of the saving and investment behavior of countries, which contributed to the global imbalances, can only be interpreted as anomaly. If that is the case, there must be some portions of current account balances or national saving or investment that cannot be explained by cross-country variations of the explanatory variables.

In fact, these regression results suggest the possibility that current accounts may have behaved atypically in the 2006–2008 period, a period with global imbalances prior to the global crisis. Figure 1.6 shows the Kernel density estimates of the distribution of the prediction errors for the groups of industrialized countries and emerging market economies when the predictions are made for the current account balances for the 2006–2008 period using the data up to 2005. Interestingly, for both groups, the distribution of the prediction errors from the regression estimation has become significantly wider in the 2006–2008 period. For the group of industrialized countries, the prediction errors are more skewed to the left and more widely distributed in 2006–2008. While industrialized countries seem to have experienced a wide variation of the prediction errors also in the 1980s and the 1990s besides the last period, the wider variation in the global imbalances period stands out for the group of emerging market countries, suggesting a possibility of a regime shift in the current account balance series in this period.

Figure 1.6 Kernel distributions of prediction errors.

Reproduced from Chinn, M.D., Eichengreen, B., Ito, H., 2011. A forensic analysis of global imbalances. Mimeo.

The estimation model performs poorly for China as well. Figure 1.7 displays the implied current account balances for China along with 95% confidence intervals of prediction that are calculated using the estimation results. The figure shows that China’s current account is well outside the confidence interval. The same kind of underperformance of the regression model is also observed for the national saving estimation, a result consistent with other studies.

Figure 1.7 Predictions of current accounts.

Reproduced from Chinn, M.D., Eichengreen, B., Ito, H., 2011. A forensic analysis of global imbalances. Mimeo.

These estimation results can be also used to see if any factors, which are not included in the estimation model and which can be more prevalent in the global imbalances period than other period, can explain the unexplained portion of current account balances for the countries. We can test to see if the portion of the current account balances that cannot be explained by the benchmark model can be explained by some variables that account for monetary or fiscal policy stance as well as those which represent the conditions of financial markets and, most importantly, housing markets. While the boom in the financial markets as well as housing markets explain some of the unexplainable portions of the current account balances, it is found that there is still a large portion of current account balances left unexplained for the countries with overly imbalanced current accounts such as the United States, the United Kingdom, Greece, Iceland, and China.

These results indicate that these countries need to implement policies that are particularly tailored for their country-specific situations that affect the saving and investment decisions in order to guide themselves toward rebalancing. In the next section, we review some of the characteristics of China’s policies and socioeconomic conditions that may have contributed to its unique saving and investment imbalances.

Explanations for China’s High Saving

China’s unique situation has led the country to experience two types of imbalances. The first is the well-known external imbalances. The second imbalance is the multifaceted pattern of China’s economic growth, which is reflected in several gaps. The first pertains to the wide income gap between industrial, high-growth coastal areas and agricultural, underdeveloped inland regions, which was essentially a result of the longtime emphasis on market-driven economic experimentation in the coastal cities. The second pertains to the gap between growth in the returns to capital versus labor. While the corporate sector profits, especially those of the manufacturing sector, have risen continuously throughout the 2000s, labor income has been declining in the same period. Both manufacturing-oriented industrialization and declining labor income have contributed to the third aspect of unbalanced growth, which is the rapid rise in savings, especially those of corporate and household sectors.

Figure 1.8 shows that, while the level of national investment of China has been fairly high in recent years, that of national saving has been even higher, the difference between the two accounting for the magnitude of the current account surplus. Hence, understanding the impact of financial globalization on China requires an examination of the growth imbalances that have contributed to China’s unique saving behavior. For that purpose, we need to examine China’s domestic savings from the perspective of the flow of funds.

Figure 1.8 China’s national saving and investment.

Source: World Development Indicator.

Figure 1.9 displays the development of national savings in three sectors: household, corporate, and government. Since 2001, the level of aggregate national saving has been rising steadily through 2008. While household saving was the main contributor to the aggregate saving before 2000, both household and corporate savings have been the main contributors since then. During the last few years of the sample period, or the global imbalances years, household saving became the largest contributor again. However, it is also noteworthy that during the same period, government saving has been rising rapidly after having played a minor role for a long while.

Figure 1.9 Compositions of China’s national saving (as a percentage of GDP).

Reproduced from Ma, G., Wang, Y., 2010. China’s high saving rate: myth and reality. BIS Working Paper No. 312 (June); China National Bureau of Statistics; Additional information from Menzie Chinn, and Hiro Ito, Financial Globalization and China (8/3/11).

Below, we will only briefly review what kind of economic and socioeconomic factors as well as government policies have contributed to the different paths of development for each of the three sectors’ savings.

Financial Development and Corporate Finance in China

As was in the case with other East Asian economies such as South Korea and Japan, China’s rapid industrialization has been achieved through tight state controls on the financial system, which allowed (initially scarce) capital to be allocated to ‘strategically’ important industries. In such financially repressed financial markets, the cost of capital would usually be artificially maintained low. The government, hoping to jump-start economic development with robust export growth, would encourage cheap capital to be allocated to capital-intensive industries such as heavy and manufacturing industries that would produce tradable goods. While this sort of developmental strategy is typical among emerging market economies, what is unique about China’s case is that: (1) because of its communist past, the state-owned enterprises (SOEs) have played an important role in industrialization and export growth as well as in capital allocation process; (2) because of more direct government involvement in industrial policy and corporate finance (in contrast to more private–government collaborations in the case of Korea and Japan), the government policies have been much less responsive to market forces, resulting in overinvestment in certain industries; and that (3) the lack of responsiveness to market forces also helped the country to lack a scheme that would redistribute the benefits of capital-intensive industrialization to workers in the forms of distribution of dividends.

Such a state-dominant financial system may have been effective in capital allocation, but has clearly been an obstacle to the marketization process in the financial sector, making financial development lag behind overall economic development. It is the gap between the impressive economic development and China’s financial underdevelopment that has contributed to a rapid raise in corporate saving. That is, even after many corporations, including both state and nonstate owned, improved profitability in the robust economy in the 2000s, the financial sector continued to be dominated by SOEs and failed to provide attractive financial instruments, to which corporate profits could have been invested. Also, until recently, the government did not create a scheme to force corporations to redistribute dividends to shareholders (i.e., the government in the case of SOEs). Furthermore, in such an environment, where financial resources are not allocated based on market signals, internal earnings functioned as an important alternative financing source for firms.

The inevitable consequence of all these conditions is a rise in corporate saving; due to the lack of financial development, corporate profits are neither effectively reinvested in financial instruments nor redistributed as dividends. For this sort of financial system, one could argue that one effective way to lowering China’s high saving is to implement policies to allow corporate profits to be effectively reinvested or redistributed as dividends. However, that outcome is likely to occur only in the long term.

Household Behavior

The peculiarities of China’s economic and financial development have also affected households’ saving behavior. The government’s focus on capital-intensive, tradable industries led to overconcentration of labor force in the manufacturing sector. The situation with labor surplus is worse in the urban areas due to constant migration from the rural areas while the government’s tight controls of labor unions has also discouraged workers’ demand for higher wages. All these factors have contributed to a declining labor income share in the economy. Furthermore, net interest income declined by about a half between 1992 and 2007, so did net transfers from the government, it has been found, mainly because of the increased contributions to pension funds and other welfare obligations.

While the household income share dropped, the average propensity to save (as a share to GDP) went up by 10 percentage points in the 2000s, resulting in a shrinkage of private consumption and a rise in household saving, both as shares in GDP.

These changes in the household saving in China can be attributed to both macroeconomic factors as well as institutional factors. The life cycle, permanent income hypothesis can be a good macroeconomic factor. Since 1980, the working-age share of the population rose from 60 to 74% in China, undoubtedly contributing to increasing the household saving rate. A combination of sluggish change in the consumption behavior and rapid output growth also contributed to a rise in the household saving rate, which is quite common among high-growth developing economies.

Furthermore, the restructuring and streamlining efforts as part of the marketization of the corporate sector after the 1990s, along with the large-scale influx of migrants from the rural areas, have made the labor markets highly fluid and led to a drastic shrinkage of the once comprehensive ‘cradle-to-grave’ social safety net, or ‘iron rice bowl.’ Many argue that these trends have motivated Chinese households toward precautionary saving.

Limited accessibility to mortgage financing despite increased private house ownership has also been argued to be a factor for the high household saving rate in China. According to a recent empirical study, 82.3% of urban ‘registered city residents’ (or city hukou holders) own houses. This figure has been growing rapidly nationwide. However, due to the lack of financial development as well as risk averseness of the government authorities and financial institutions, mortgage financing has been relatively limited, requiring a high down payment requirement and thus motivating Chinese people to save.

Government Saving

As Figure 1.9 illustrates, government saving has been playing a minor role compared to the other two sectors. However, it has been rising rapidly in recently years and becoming a major contributor to the rise in China’s national saving.

The rise in government saving is a reflection of a rapid rise in government income, which is also an outcome of rapid economic growth. As it has taken a while for the households to change their consumption behavior to catch up with the rapid economic growth, the same phenomenon has been in place for the government. Now the question is, why has the government consumption level been relatively stable and low, making its saving high, despite a rapid increase in its income?

The first reason for the recent rise in government saving is the government’s emphasis on investment for infrastructure building and other growth-enhancing economic policies. This type of initiatives through active investment is a legacy of the communist style policy implementation. The central government also appropriate a share of fiscal revenue to less well-funded local governments or provide capital transfers to related SOEs to execute national growth-oriented policies. Growth-enhancing projects are viewed as important at all government levels because promotions of government officials are often predicated on the performance of the economies under their jurisdiction. Whether it is implemented at the central or local levels, this type of investment is not counted as government consumption, but counted as government saving.

Second, the pension system reform implemented in 1997 as a preparation for anticipated aging population has contributed to a rise in government saving. As a result of an increase in pension contributions, the government’s holding of both financial and physical assets has increased in recent years, adding to government saving.

Thus, a strong emphasis on growth-oriented investment and preparation for future demographical changes (i.e., aging population) are the main contributors to the recent rise in government saving. However, these types of increase in government saving or investment will also mean that government consumption will have to rise in the future. That means government saving is to fall in the relatively near future, though probably not at the pace the critics of China’s high saving in the rest of the world hope for.

Financial Globalization and China’s High Saving

China’s path of development has incorporated a unique approach to financial globalization, associated with a high degree of distortion, manifesting in excessively high levels of savings in both the private and public sectors. In the absence of determined measures to correct the distortions, the extent of both external and internal imbalances may very well become greater. In principle, the development of financial markets could mitigate these distortions. In particular, introducing more market mechanisms could help unclog the flow of funds within the Chinese economy and reduce the accumulated savings in the country. Thus, developing domestic financial markets is a necessary ingredient of China’s further