1. 1 The Financial role of East Asian Countries in Global Imbalances: An Econometric Assessment of Developments after the Global Financial Crisis June 2013 Hyun-Hoon Lee Kangwon National University, Korea Donghyun Park Asia Development Bank, Philippines “The Global Economy” conference (University of Tokyo, 15-16 March 2013).

2. 2 In the wake of the global financial crisis, the phenomenon of global imbalances has been at the center stage in the debates about the causes of the global financial crisis and reform of the international financial architecture. Global imbalances are characterized by large US current account deficits funded primarily by East Asian countries and oil producing countries. 1. Introduction

3. Since the late 1990s, the US current account deficits grew until 2006 when it reached over 1.5% of world GDP. China’s current account surplus increased remarkably fast until 2008. Japan’s surplus also continues to be large and the current account surplus of other East Asian countries are not negligible.

4. Since the late 1990s the US current account deficit grew continuously to exceed 5% of US GDP in 2003. It peaked in 2006 at over 6%. The counterparts to the US current account deficits were the large surpluses of China, Japan and OPEC member countries. The current account deficit of the US relative to its GDP has fallen since the global crisis, suggesting a decline in global imbalances.

5. China’s relative contribution to US current account deficits grew remarkably rapidly, even after the global crisis. Japan’s share also increased after the crisis. Thus, East Asia’s share of the US’s total current account deficit has increased.

6. 6 Understanding the factors behind the global imbalances matters for assessing how global imbalances may evolve in the future. It also matters for assessing the potential threat the imbalances pose to future global financial and economic stability, along with the measures that policy makers must take to “rebalance” the global economy. 1. Introduction

7. 7  Two conflicting views on the roots and sustainability of global imbalances (1) Global imbalances are an unsustainable phenomenon, whose impending correction must entail US current account adjustment and a sharp depreciation of the US dollar coupled with a sudden stop of capital flows into the US (See, e.g., Roubini 2008; Roubini and Mihm, 2010). - Focus on current account imbalances. (2) Global imbalances represent an equilibrium situation that, absent changes in its underlying determinants, can be self-sustaining. - In other words, global imbalances are the result of fundamentals and/or policies adopted by other countries that have led to a steady accumulation of US assets by the rest of the world. -Thus, without changes in such fundamentals and policy choices, global imbalances could persist. - Focus on capital account imbalances.

8. 8 1. Introduction  Main Objectives We aim to assess whether global imbalances have undergone any fundamental structural changes since the global financial crisis of 2008. In particular, we aim to assess whether the investment positions of China and other East Asian countries in the US financial market changed in such a way to alleviate the global imbalances.

9. 9  Contents of this paper 1. Introduction 2. Trend of East Asian Holdings of US Financial Assets 3. Empirical Specifications 4. Empirical Results 5. Concluding Observations 1. Introduction

10. 10 2. Descriptive Analysis  Data US Treasury Department, Treasury International Capital (TIC) TIC system provides data on cross-border portfolio investment positions between US residents and foreign residents. It also provides monthly and quarterly position data on bank claims and liabilities by country.

11. Global imbalances of the last decade have been accompanied by massive capital flows from East Asian countries to the US. Even after the global crisis, East Asian countries’ investment in the US continued to grow. China is the biggest investor in the US, followed by Japan.

12. This pattern is especially visible in long-term bond investment.

13. Magnitude of Asia’s equity investment and bank lending are relatively small.

14. China has increased its portfolio investment very rapidly. East Asian countries’ investment in the US continued to grow.

17. 3. Empirical Specification  Benchmark specification As an alternative, Santos Silva and Tenreyro (2006) suggest that the gravity model be estimated in its multiplicative form and use a Poisson pseudo- maximum likelihood (PPML) estimator that is usually used for count data.

18. 3. Empirical Specification  Specification with year-specific effects To ask whether the "excessive" holdings of US securities by East Asia has built up gradually before the crisis and then declined gradually after the crisis

19. 3. Empirical Specification  Specification with country-specific effects To compare how different East Asian countries behave differently in holding US securities.

20. 4. Results Table 5. Determinants of Foreigners’ Holdings of US Securities: PPML Model Table 6. Determinants of Foreigners’ Holdings of US Securities: Random Effects Model Table 7. Determinants of Foreigners’ Holdings of US Long-term Bonds: PPML Model Table 8. Year-specific East Asian Effects as Determinants of Foreigners’ Holdings of US Securities: PPML Model Table 9. Country-specific East Asian Effects as Determinants of Foreigners’ Holdings of US Securities: PPML Model

28. 28 5. Concluding observations  Main findings Our regression results show that although the relative ‘excessive’ investment of most East Asian countries in the US, has declined somewhat since the global crisis, it still remains substantial. This pattern is especially visible in long-term bond investment of China.

29. 29  Implications Our results support the view that the imbalances are an equilibrium state conditional on the various fundamentals underlying the capital markets and hence the present imbalances may persist unless the fundamentals are addressed. In particular, the increase in East Asia’s relative contribution to global imbalances indicate that the internal fundamentals of East Asian countries have not changed since the global crisis. 5. Concluding observations

30. 30  Underlying forces of Trans-Pacific imbalances The underdevelopment of social safety nets, especially in China, combines with the underdevelopment of financial markets to drive enormous amounts of East Asian investment into financially developed advanced economies, especially the US. Whether out of mercantilist, export-promoting purpose or precautionary self-insurance against financial shocks, the East Asian region is continuing to amass foreign exchange reserves in the form of safe bonds such as those of the US. This accumulation underlies the persistence of global imbalances. 5. Concluding observations

31. 31  Policy suggestions There is a need for China and other East Asian countries to strengthen their social safety nets so as to curtail excessive savings and thus nurture healthy consumption. Furthermore, East Asia should strive to refrain from disproportionate foreign exchange rate accumulation and shift toward a growth paradigm in which domestic demand plays a larger role. In the long run, the region should strive for broader, deeper, more liquid and more sophisticated financial markets. In this connection, it is necessary to further expand and strengthen the Chiang Mai Initiative, which emerged as a regional Asian response to the Asian crisis, and the Asian Bond Market Initiative. 5. Concluding observations