Reducing the U.S. Deficit by Recycling Capital Inflows
The United States can simply recycle the financial capital inflows from China
and re-export them back to China in the form of FDI. In so doing, the United
States gains a substantially larger rate of return from FDI than China does
from owning U.S. government bonds.
The United States has been running large and persistent trade deficits with
other economies, especially emerging markets such as China, for decades.
Persistent trade imbalances imply that the United States has been consuming
more than it produces or, equivalently, saving less than it invests. This means
that the United States has been borrowing heavily from foreigners (especially
China) to finance its domestic investment.
Critics say that to rebalance its current account the United States needs to
either increase its saving rate or lower its investment rate. Both approaches
are painful for the U.S. economy and will lead to lower aggregate demand and
hence slower economic recovery. However, the very nature of the trade deficit
itself offers a solution.
A trade deficit in a country’s current account is the same thing as a surplus in its capital account. For
example, China’s trade surplus with the United States must be balanced by its investment in
U.S. assets (or by holding dollars as foreign reserves). This accounting
identity suggests a solution for resolving the U.S.-China trade imbalance
problem without lowering U.S. aggregate demand.
Here is the underlying logic. First, we need to understand why China is willing
to lend to the United States when it is still struggling with low consumption
per capita. The answer is that Chinese households need to save for
precautionary reasons but do not have good domestic investment opportunities
for their savings. Hence, financial capital (demand for liquid financial
assets) tends to flow abroad from China to more developed economies (especially
the United States) because household savings in China cannot be channeled
effectively to its production sector. In other words, private firms in China
are not able to gain free access to household savings despite rapid
productivity growth. So China’s excessive saving rate is not matched by its domestic investment rate. This
mismatch, in turn, implies that the rate of return to fixed capital in China’s private production sector is significantly higher than it is in the United
Indeed, the real rate of return to fixed capital in China has exceeded 20
percent in the past two decades, while the real rate of return to financial
capital (such as bank deposits and short-term bonds) has been negative. Despite
such an enormous gap, households in China save excessively in the form of bank
deposits, indicating severely underdeveloped financial markets within China.
This lack of a sophisticated financial system has been driving China’s household savings into the United States to seek safer and better returns (see
Wang, Wen, and Xu, 2012).
However, the enormous gap between returns to household savings and returns to
fixed capital in China also offers a tremendous profit opportunity for U.S.
investors, especially U.S. firms. Basically, the United States can simply
recycle the financial capital inflows from China and re-export them back to
China in the form of foreign direct investment (FDI).1 In so doing, the United States gains a substantially larger rate of return from
FDI than China does from owning U.S. government bonds.
FDI outflows from the United States to China can offset China’s massive financial capital flows into the United States and help rebalance
America’s large trade deficit
with China. In other words, American firms can reinvest China’s cheap financial capital inflows (household savings) back in China in the form
of FDI to earn higher rates of return than the Chinese do by holding U.S.
Treasury notes. Namely, the United States receives (borrows) cheap savings from
the Chinese, and U.S. firms use those savings to set up new firms or buy
existing firms in China. Given China’s high rate of return to capital in its production sector, American firms can
gain significantly more in such a two-way capital flow process than the Chinese
savers could. From the viewpoint of the current account, this process of
capital recycling amounts to letting the Chinese produce labor-intensive
consumption goods for the United States and Americans produce capital goods for
China, which uses both countries’ comparative advantages and is thus a win-win solution for trade imbalances
between the two nations.
Therefore, rebalancing its trade deficit with China does not mean American
consumers need to tighten their belts or American firms need to lower their
domestic investment rate. Instead, the U.S. government can encourage U.S. firms
to produce more capital goods and send them to China in the form of FDI, which
has been strongly favored by the Chinese markets. This approach will also
increase U.S. employment in the manufacturing sector. Ironically, the current
U.S. policy in practice discourages American FDI outflows to China rather than
encourages them, as the government fears technology transfers and losses of
domestic employment. For example, in 2010 the total accumulated FDI outflows
from the United States to China and other less developed countries accounted
for just 5 percent of U.S. gross domestic product, whereas the total financial
capital inflows into the United States from China and other less developed
countries accounted for more than 25 percent. This imbalance of two-way capital
flows and policy orientation toward American FDI outflows have exacerbated the
U.S.-China trade imbalance problem.
1 FDI is investment directly into production in a foreign country by a domestic
firm, either by buying a company in the foreign country or by expanding
operations of an existing business in that country. So FDI implies sending
capital equipment to foreign countries.