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Explaining China's Trade Imbalance Puzzle

The current global-imbalance literature (which explains why capital flows from poor to rich countries) is unable to explain China’s foreign asset positions because capital cannot flow out of China under capital controls. Hence, this literature has not succeeded in explaining China’s large and persistent trade imbalances with the United States. A closely related but deeper puzzle that this literature fails to address is China’s high household saving rate despite an astonishingly rapid income growth rate. This paper shows that a modified (and calibrated) Melitz (2003) model can qualitatively and quantitatively explain China’s trade surplus and its massive accumulation of low-yield foreign reserves. The simple infinite-horizon model is also consistent with the stylized fact that high saving is the consequence of high growth (Modigliani and Cao, 2004), which the permanent income theory and global-imbalance literature fail to predict.

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