Neither a borrower nor a lender : does China's zero net foreign asset position make economic sense?

WPS3801 Neither a Borrower Nor a Lender: Does China's Zero Net Foreign Asset Position Make Economic Sense? David Dollar and Aart Kraay The World Bank Abstract: China in the past few years has emerged as a net foreign creditor on the international scene with net foreign assets slightly greater than zero percent of wealth. This is surprising given that China is a relatively poor country with a capital-labor ratio about one-fifth the world average and one-tenth the U.S. level. The main questions that we address are whether it makes economic sense for China to be a net creditor and how we see China's net foreign asset position evolving over the next 20 years. We calibrate a theoretical model of international capital flows featuring diminishing returns, production risk, and sovereign risk. Our calibrations for China yield a predicted net foreign asset position of -17 percent of China's wealth. We also estimate non-structural cross-country regressions of determinants of net foreign assets in which China is always a significant outlier with 5 to 7 percentage points more of net foreign assets relative to wealth than is predicted by its characteristics. China's extensive capital controls can explain why its current net foreign asset position is far away from what is predicted by open-economy models and cross-country empirics. It seems reasonable to assume that China's international financial integration will increase over time. We calibrate and predict different scenarios out to 2025. These scenarios are necessarily speculative, but it is interesting that they typically imply negative net foreign asset positions between 3 and 9 percent of wealth. What may be counter-intuitive for many policy-makers is that successful institutional reform and productivity growth are likely to lead to more negative net foreign asset positions than occurs with stagnation. Starting from China's zero net foreign asset position, it would take current account deficits in the range of 2-5 percent of GDP to reach any of these future net foreign asset positions. These are not unreasonable deficits, but they require a large adjustment from the present 6 percent of GDP current account surplus. World Bank Policy Research Working Paper 3801, December 2005 The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the view of the World Bank, its Executive Directors, or the countries they represent. Policy Research Working Papers are available online at http://econ.worldbank.org. __________________________________________________________________ 1818 H Street N.W., Washington, DC 20433, ddollar@worldbank.org, akraay@worldbank.org. This paper was prepared for the Carnegie-Rochester Conference Series on Public Policy held in Pittsburgh on November 17-18, 2005. We are grateful to conference participants and especially our discussant, Shang-jin Wei, for helpful comments. We also thank Philip Lane and Gian Maria Milesi-Ferretti for sharing their preliminary estimates of China's net foreign asset position through 2003; Natalia Tamirisa for sharing her data on capital controls; and Xiaofan Liu for her help with Chinese statistics.  1. Introduction China in the past few years has emerged as a net creditor on the international scene. This development is surprising given that China is still a relatively poor country with per capita GDP of $5000 in 1996 PPP terms and a capital-labor labor ratio about one-fifth the world average and one-tenth the U.S. level. Neoclassical theory suggests that the return to capital in China should be relatively high and that in an increasingly integrated world economy the rest of the world should be a net lender to China rather than a net borrower from it. There are plenty of institutional weaknesses and distortions that can keep the return to capital in developing countries low, despite a low capital-labor ratio, but anecdotal evidence suggests that the return to much of the investment in China is quite high. Certainly the typical Fortune 500 company finds China more attractive than most other developing countries. The main question that we address then is whether it makes economic sense for China to be a net creditor. Or, more generally, what is the expected net foreign asset position of China given its productivity level, its stock of capital, and its population, relative to the rest of the world? We are interested in answering this question in light of the most recent data. But an even more interesting question is what we expect China's net foreign asset position to be in 15 to 20 years. It is likely that market reforms