Trade Balance

1. Trade Balance

2. National Income Accounting • Y=C+I+G+NX (Income-expenditure identity) • Y=GDP (gross domestic product) • NX=EX-IM=net exports of goods & services • S=I+CA, where CA=NX+NFP • CA=current account balance • NFP=net factor payments from abroad • If S<I, then CA=S-I<0 • If a country saves less than it invests, it must run a current account surplus.

3. National Income Accounting • Spvt=I+(-Sgovt)+CA (Use-of-saving identity) • When CA is lowered, o.t.s being equal, Spvt is lowered too. (trade deficit and low private saving rate) • When –Sgovt is more positive, o.t.s. being equal, CA becomes lower (more severe gov deficit and worsened trade deficit) • Ignore NFP, focus on NX • Why NX is already zero in our course?

4. Assumed one-shot interaction A nation always consumes up its value of production (because every agent does) No reason to consume less unable to consume more Textbook treatment of NX food D Q Iso-value line cloth

5. Textbook Treatment of NX • Value of production = pCQC+pFQF • Value of consumption=pCDC+pFDF • pCQC+pFQF=pCDC+pFDF • Suppose C is exportable good; F is importable good • pC(QC-DC) - pF(DF-QF)=0 • Hence, NX=0

6. International Borrowing and Lending • International capital mobility refers to mobility of financialassets,or capital,acrosscountries. • Financial capital is a source of funds used to build physical capital (ex., factories and equipment). • International capital mobility can be interpreted as intertemporal trade: • trade of goods consumed today by borrowers in return for goods consumed in the future by lenders.

7. International Borrowing and Lending (cont.) • For any economy, there is a trade-off (opportunity cost) between consuming today and saving for the future: resources can either be consumed or saved. • To save and invest more today typically means that economies need to consume less today. • We represent this concept by drawing a special kind of production possibility frontier, an intertemporal production possibility frontier.

8. Fig. 7-5: The Intertemporal Production Possibility Frontier

9. International Borrowing and Lending • Some countries will have a comparative advantage in spending current output/income (in current consumption). • Others will have one in saving current output/ income (in future consumption). • A comparative advantage in current consumption • would mean a lower opportunity cost of spending current income. • would be reflected in an intertemporal PPF that is biased toward current consumption.

10. International Borrowing and Lending (cont.) • Suppose that the domestic country has a comparative advantage in (bias towards) current consumption, while the foreign country has a comparative advantage (bias towards) future consumption. • In the absence of international borrowing and lending, the relative price of current consumption should be lower in the domestic country. • But what is the relative price of current consumption?

11. International Borrowing and Lending (cont.) • The price of borrowing 1 unit of output/income to consume today is the output/income that needs to be repaid in the future: • principal + interest = 1+r, where r is the interest rate • The price of current consumption relative to future consumption is 1/(1+r) • The opportunity cost of consuming 1 unit of output/ income today is the output/income that could be earned by saving it: • principal + interest = 1+r, where r is the interest rate • The opportunity cost of current consumption relative to future consumption is 1/(1+r)

12. International Borrowing and Lending (cont.) • If international borrowing and lending are allowed, the domestic country will “export” current consumption (that is, borrow). • The domestic country initially has a lower relative price of current consumption 1/(1+r) • The domestic country initially has a higher interest rate r. • A higher interest rate r implies a higher return to consumption and investment in production processes: they are highly desirable and profitable so that the domestic country should borrow from foreign lenders.

13. Fig. 7A2-1: Determining Home’s Intertemporal Production Pattern

14. Fig. 7A2-2: Determining Home’s Intertemporal Consumption Pattern

15. Fig. 7A2-3: Determining Foreign’s Intertemporal Production and Consumption Patterns

16. Fig. 7A2-2: Determining Home’s Intertemporal Consumption Pattern

17. Demography: Life cycle consideration • Life cycle consideration • A country is likened to a person: save when young & working, de-save when old • Hence, when ageing, a country runs a trade surplus first, followed by a trade deficit

18. A hypothetical example • Suppose each agent lives two periods: young (working) and old (retiring). • Suppose a small country in which all residents are young but they do not decide to have children. • Suppose only one, non-storable good is produced. But one foreign asset is available (call it US treasury bond, with constant interest rate r) • Time 1: all residents are young; trade surplus • Time 2; all residents are old; trade deficit • Time 3: the country disappears; NX=0

19. Trade surplus Period 2 Period 3 Trade deficit time Period 1 A hypothetical example Trade balance

20. A hypothetical example • CA=S-I • Demography explains S. In case I is unrelated to demography or less responsive to it, then the change in S will reveal itself in CA • In China, weak financial markets prevent channeling of savings to those who have good business ideas

21. Median age: China versus US

22. Total Dependency Ratio: China versus US

23. Dependence ratio: China

24. Difficulty • The example predicts CA be negative some day. For Germany and Japan, whose populations have aged for a long time, still there is no sign their CA will become negative. • Way out: to look at richer demography that allows for richer dynamic of CA change

25. Demography Sex ratio in China (males per 100 females)

26. Demography • Sexual Imbalance (missing women) • one child policy + son preferences • Parents and their single sons save more to increase competitiveness in the marriage market • Evidence: counties with more skewed sex ratio have higher saving rates • It is argued that sexual imbalance may account of up to ½ of the China’s trade surplus with the US.

27. Data/mis-measurement problem • “Dark Matters in China’s Current Account” by Zhiwei Zhang, a staff member of HKMA • One bias due to under-estimated returns on foreign investments in China • all earnings for foreign investments should be recorded in current account as a negative item, regardless if the earnings are re-invested in China or repatriated out • Official CA statistics; official stock of FI by end of 2006 is US$1.03T; FI earnings US$57.3B in 2007 => hence, ROR 5.5% • The author’s estimate: FI earnings ~ US$109.6B • Evidence: ROR should be higher (OECD studies found 14.3%).

28. Data/mis-measurement problem • 60% of China’s exports are actually made by foreign funded firms • China has been top exporter of cell phones and notebook computers, but the cell phones are mostly made by Nokia and Motorola, and notebooks by Dell and HP. • The importance of foreign capital is asymmetrically reflected in China’s current account • the explosive growth of exports (largely due to foreign firms moving production bases into China) are well recorded, • But the profits foreign firms made into China are substantially under-recorded.

29. Data/mis-measurement problem • Another source of bias: capital inflows misreported as trade surplus. • The expectation for RMB appreciation heightened in mid 2004, and made one-way bet for RMB a profitable arbitrage opportunity. • Firms in China can over-report their exports and under-report their imports. • China’s current account surplus is over-estimated, and capital account surplus is under-estimated. • Misreported capital flows through the trade channel amounts to 1.9% of GDP in 2007.

30. Data/mis-measurement problem • Accounting for Growth in China’s Exports by Firm Ownership

31. Other explanations • S=I+CA • It is China, stupid! • Currency manipulation (RMB undervalued) • Mercantilism (export is good, import is bad) • Saving rate too high (culture?) • Poor financial market • It is US, stupid! • Saving rate too low (culture?) • Developed financial market • J.M. Keynes: “If I owe you a little money and I don’t repay, I have trouble. If I owe you a lot of money and don’t repay, you have trouble!”

32. Prognosis: China as a transformative /de-stabilizing factor • Increasing economic power • Education attainment • 2000: 1 million college students graduated • 2010: more than 6 million college students graduated (c.w. 3.5 million first year students in US in 2008) • Now 22% of the cohort go to college • Rate of return of capital has no sign to slow down • Destabilizing the global order • But growth will slow down one day… • Income inequality

33. Prognosis: China as a transformative /de-stabilizing factor • Sexual imbalance • 1.7 million un-marriageable boys being borne each year • =5 times of the total girls borne a year in Canada (around 330K) • =50 times of the total girls borne a year in HK (around 30K) • Lack of non-material ideals • Communist Party an effective autocracy forever? • 1949-1978: passion • 1979-2008: interest • 2009-2039: ??

34. Topics • Trade balance & capital flows • Textbook case • Data problem • Demography • Lack of investment opportunity • Undeveloped financial market • Exchange manipulation • Culture—saving glut