How the Current Account Dwarfs the
Capital Account: China’s Incongruous
Role in the World Economy
Dirk H. Ehnts and Finn M. K¨
this version: October 1, 2009
The integration of China into the world economy has done its part to in-
crease global imbalances. Relying on export-led growth, the country’s quasi-
ﬁxed exchange rate against the US dollar has led to much debate. While a lot
of discussion focussed on the question of sustainability, few paid attention to
the consequences of the Chinese strategy for the US ﬁnancial market. After
explaining in detail China’s policy of sterilization of capital inﬂows we turn to
the US ﬁnancial market and revisit the consequences of the additional Chinese
demand for US assets. We ﬁnd that the bubbles in the real estate and stock
markets have indirectly been fuelled by Chinese hunger for US government
debt. Therefore, the Chinese growth strategy is the demand side explanation
of the ﬁnancial crisis, explaining why the supply of toxic assets by US ﬁnancial
institutions found its buyers.
JEL classiﬁcation: E22, F32, F34
Keywords: International economic order, Keynes, ﬁnancial crisis, Bretton Woods II
Preliminary draft. Do not cite. Do not distribute.
∗ Fak.II-VWL, Carl von Ossietzky Universit¨at Oldenburg, 26111 Oldenburg, Germany.
Contact: firstname.lastname@example.org; ﬁnn.email@example.com; uni-oldenburg.de/iw
The integration of more than 1.3 billion people into the world economy is no easy task,
and it is not made easier by the fact that China is a developing country with a Communist
government and not much experience with market-led capitalism. Although incomes are
low, its sheer population size is the reason that the Chinese economy is the third largest in
the world.1 Its population is still mostly rural and a demographic problem looms large in
the background. The one-child policy has led to an aging society which will have trouble
supporting its elderly, given that the social security system is weak. The Chinese economy
is still widely regulated with most ﬁrms under government control. However, China is
slowly changing toward market-led capitalism.
China has chosen to follow an export-led growth strategy.2 This is aimed to solve
some of the government’s most urgent problems. The major issue is economic growth.
Without it, the political climate would degenerate and probably lead to social unrest
which has so far been limited by (prospects of) economic growth. Creating jobs therefore
is a major priority. Since some hundreds of millions of Chinese still live in rural poverty,
an extensive growth strategy of putting these people to work looks very attractive.3 The
big question in a planned economy is where to put the extra workers. Since in a planned
economy there are no markets which coordinate resources via a price system, it is diﬃcult
for the economic planner to single out the sectors and products which should be expanded.
This might be one explanation why China is relying on exports. World market prices are
known, and hence exporting ﬁrms know whether to expand production or not. Therefore,
the external sector has been expanded more quickly than the economy has grown on
average. To protect itself from tariﬀs and non-tariﬀ barriers that might obstruct its
exports, China has joined the World Trade Organization in December 2001.
Trade theory predicts that China should use its relatively abundant factor intensely,
which is unqualiﬁed labor thus exporting labor-intensive goods at very low prices. Factor
price equalization does not hold because the productivity of Chinese workers is far from
that of workers in developed countries. Recently, access to technology has played a greater
role in the Chinese growth model. Foreign direct investment and the formation of joint
ventures were encouraged. China has understood that intensive growth through a more
and better educated workforce can help it sustain its high growth rate.
The success of China’s external sector comes at a price. China, which by now (Septem-
ber 2009) is the world’s biggest exporter,4 has also become a large net exporter. Having
quasi-ﬁxed its exchange rate against a basket of currencies, mainly the dollar, this would
result in a massive increase of the monetary supply if not for the sterilization conducted
1 See the IMF’s World Economic Outlook Database, April 2009.
2 Other Asian countries follow the same strategy.
3 See the model of Lewis (1954), in which low productivity workers in rural areas migrate to cities where
their productivity is positive.
4 http://www.china.org.cn/business/highlights/2009-07/23/content 18192373.htm
by the People’s Bank of China (PBC).5 This operation will be made explicit in the next
section. At this point it suﬃces to say that the Chinese government has chosen to steer
the course regarding a ﬁxed exchange rate and that it commits its monetary policy to-
wards this goal.6 In terms of the impossible trinity, this means that China must enforce
capital controls and cannot fully liberalize its ﬁnancial market.7
While the export-led growth strategy has provided China with many years of near
double-digit growth, its sustainability is questionable. Apart from social and environ-
mental costs, some economists doubt that the rising global imbalances can go on for
much longer.8 The discussion of the so-called Bretton Woods II (BWII) system, which
supposedly allowed China and the US to enter a symbiotic relationship to the beneﬁt
of both, played a vital part . While much of the discussion focussed on the exchange
rate and the price of the US dollar, the impact of BWII on the US ﬁnancial market was
mostly neglected. In the next chapter, we try to ﬁll that gap by conducting a structural
analysis. We will discuss the results of the analysis in the constext of savings-investment
imbalances. We summarize our ﬁndings in the conclusion.
2 Global Imbalances from an Accounting Perspective
2.1 The Money Link between China and the US
The Chinese money market exhibits some particularities concerning the way foreign and
domestic currency is treated and money is held within the economy the details of which
are worth dissecting. The mechanism needs to be viewed in the light of the Chinese
authorities’ objective of both controlling the exchange rate and putting capital controls
in place (Mussa 2008, p. 293). Access to foreign capital and assets is thus restricted for
Chinese savers and, vice versa, foreign investors have only limited possibilities of spending
money in the Chinese market.
Striking a balance between the oﬃcial goal of furthering growth via exports and
maintaining a competitive exchange rate of the yuan towards the US dollar demands a
carefully designed mechanism. Its workings can best be illustrated by using an example
of a Chinese company exporting goods to the US and looking at the ensuing ﬂow of do-
mestic (yuan) and foreign (dollar, denoted by an asterisk) money. The Chinese money
market does not feature market behaviour in the sense of foreign exchange markets of
freely ﬂoating currencies. It may thus be better to use separate balance sheets for pub-
5 Cf. Regulations of the People’s Republic of China on Foreign Exchange Administration, Decree of
the State Council No. 532, 05 Aug 2008.
6 Critical assessments from US congress can be found in Frankel (2006).
7 There is some foreign direct investment ﬂowing into China, but it has to be balanced by capital out-
ﬂows managed by China’s government-sponsored sovereign wealth fund. Regular Chinese companies
are not even allowed to hold foreign exchange change.
8 An example provides Mussa (2007).
lic (government and central bank), corporate (export and manufacturing industry) and
private (households and savers) actors. The public sector is represented by one single
entity since the People’s Bank of China (PBC), the Chinese central bank, is regarded9 as
dependent on the inﬂuence of the authorities.
Let us follow Chinese exports and the resulting ﬂows of money to an American im-
porter. Since the majority of Chinese exports is invoiced in US dollars, the exporting
company is paid in dollars in return for the sold products. Holding dollars however is
restricted in China (Kanamori and Zhao 2006, p. 2); the PBC mops up all incoming dol-
lars by converting them into yuan at the prevailing exchange rate so that the exporter is
left with yuan in exchange for its produce. Nonetheless, the PBC cannot just print yuan
incessantly for this would create domestic inﬂation. The detour which was developed to
sterilise the inﬂow of dollars involves issuing bonds to domestic corporate banks (Siebert
2008, p. 55); Chinese consumers, in need to save for high age, take their money to the
bank which provides the PBC with interest on its loan — in yuan. The circle is therefore
closed — no additional money has been created and only credit has increased.
The system works as long as Chinese depositors have suﬃcient conﬁdence in the money
they are holding in their bank accounts. If ever they lost this conﬁdence it would result
in a withdrawal of funds and destroy the sterilisation mechanism of the PBC. Foreign
reserves thus play a crucial role since they can be used to directly back corporate banks
with a bad loans portfolio (Siebert 2008, p. 54) and on the other hand they are the
underlying of the bonds issued to those banks. Looking at the balance sheets of the
three parties involved, one can easily see the eﬀects: temporary changes are denoted by
single arrows (↑↓), permanent ones by a double arrow (⇑⇓). We can therefore see that
lasting changes are made to the central bank’s reserves, Fcb, on the asset side and its bond
liabilities, Bcb ⇑. The exporting company swaps produce (capital goods Kc ⇓) against
domestic money, Mc ⇑, while the private households reduce their money holdings, Mc ⇓,
and increase their bond holdings, Bp ⇑ — the latter can also be part of the monetary
base since the bonds are possibly of a shorter term nature. The respective balance sheets
are presented in Table 1.
The outcome of this mechanism is no surprise. The mounting pile of Chinese foreign
exchange reserves, denominated in US dollars, has been watched with suspicion for the
past decade.10 Any surplus of exports over imports leads to an increase in foreign exchange
reserves of the Chinese central bank and triggers the sterilization process.
9 cf. Mussa (2007, p. 3) or He and Pauwels (2008, p. 3)
10 cf. among others Eichengreen (2004), McKinnon (2008) or Palley (2006).
(a) Balance sheet of the public sector/central bank
FX reserves Fcb ⇑
Base Money Mcb ↓↑
Net dom. assets Acb
Bonds Bcb ⇑
Net wealth Wcb
(b) Balance sheet of exporting companies
(c) Balance sheet of private households
Money holdings M ∗ ↑↓
Money holdings M
Money holdings Mc ⇑
Bonds Bp ⇑
Capital goods Kc ⇓
Net wealth Wc
Capital goods Kp
Net wealth Wp
Table 1: Balance sheets of the public (a), corporate (b) and private (c) sectors; cf. Vollmer
2.2 US Money and Capital Markets – Willing Recipients of Money
On the other side of the Paciﬁc, Chinese goods make their way to the American consumer.
For convenience, and in order to reﬂect the close to zero or even negative US private real
savings rate of the past years, an increase in liabilities (Lp ⇑) is assumed to ﬁnance the
purchase. The increase in money holdings (Mp) is spent directly on the purchase of the
imported consumption goods (Kp ⇑). In accounting terms, the transaction equals an
extension of the balance sheet on both sides without aﬀecting net wealth (∆Wp = 0).
The interesting question is what happens to the dollars the US customer has paid for
the product from China? Since the Chinese central bank is loath to convert the US dollars
into yuan because of the ensuing pressure to appreciate the yuan’s exchange rate vis-`
the US dollar it keeps its dollar holdings. It does not keep them in cash (Siebert 2008, p.
55) but invests them partially in dollar denominated assets. The PBC does not publish
any ﬁgures but pundits estimate that around 70% of Chinese foreign exchange reservers
are held in US dollar denominated assets; this would account for around $1,500bn of
the $2,131bn the PBC reported in its Monetary Survey as of June 200911; furthermore,
net foreign asset holdings amount to $1,858bn of which $776.4bn were in US Treasury
securities12 — thus about half of the Chinese dollar reserves are oﬃcially invested in US
Holding interest-bearing assets is better than keeping cash under the mattress. Hence
Chinese activity in US dollar-denominated asset markets is considerable. In buying Trea-
sury securities, the Chinese central bank competes with individual and institutional savers,
11 PBC Monetary Survey: http://www.pbc.gov.cn/english/diaochatongji/tongjishuju/, last accessed:
http://www.treas.gov/tic/mfh.txt, last accessed: 09/2009
pension funds and other investors in the US markets for the limited supply of debt in the
US. The latter group’s rationale is the obvious portfolio choice of holding secure assets
like T-bills, T-notes or T-bonds. We will not go into the various motives for holding these
assets but just assume that they would like to keep a share of their portfolio in these asset
The Chinese, however, in having a surplus of US dollars from their export activities
now enter the US money and capital markets in addition to the existing market partici-
pants. Since the PBC’s primary aim is to guarantee the long-term face value of the dollars
it keeps in its vault, it invests heavily in US Treasury securities as laid out above. The
Chinese purchase of US Treasury’s liabilities (Lgvt ⇑) and the money received in return
(Mgvt ⇑) can be accounted for using the balance sheets as seen in Table 2.2. This demand
meets, at least in the short term, a constant supply of debt obligations issued by the
Treasury which triggers a change in either prices or quantities in the market — the latter
via crowding other investors out.
It remains unclear, though, what happens to those investors who would have bought
US Treasury securities had the Chinese not invested their dollar holdings in the US.
Whether the Treasury increases its supply of debt – trade statistics and the current
account deﬁcit with China are known at the time the Chinese invest the proceeds of this
deﬁcit in the US so that the Treasury could issue more debt, e.g. by exhibiting “ﬁscal
irresponsibility”13. The other option is for US savers to enjoy the fruits of consumption
and forego the — anyway low — interest on savings in the US and reduce private savings
in consequence. This development is already visible in the data (Frankel 2006, p. 4) but it
is questionable whether it follows from reduced investment opportunities due to Chinese
activity or whether it is caused by other factors.
2.3 Empirical evidence
The Monetary Survey of the People’s Bank of China presents the oﬃcial ﬁgures on mone-
tary and ﬁnancial aspects published by the Chinese authorities. Since the end of the last
century, Chinese net foreign assets have grown at a monthly rate of 2.25%, equalling 9.3%
p.a on average. Over the past ten years, this amounts to a monthly increase of 150bn
yuan averaging $21.2bn per month at the respective exchange rates or $2,420bn in total.
The development of the changes of Chinese net foreign assets is shown in ﬁgure 1(a) on
a monthly basis. Since the exact composition of the assets is unknown, one can only
assume that a large part of them is invested in the U.S. as indicated by the U.S. Treasury
ﬁgures cited earlier. A comparison with the overall Chinese trade balance of goods and
services shows the same trend as the change in net foreign assets.14 If corrected for the
13 Some scholars seem to argue on these lines, cf. (Frankel 2006, p. 3)
14 Data on trade statistics is obtained from the oecd’s Main Economic Indicators and calculated as
exports f.o.b. – imports f.o.b. on a monthly basis.
(a) Balance sheet of the central bank
FX reserves Fcb
Base Money Mcb
Net dom. assets Acb
Capital goods Kcb
Net wealth Wcb
(b) Balance sheet of the US Treasury
Money holdings Mgvt ⇑
Liabilities Lgvt ⇑
Public goods Kgvt
(c) Balance sheet of private households
Money holdings Mp ↑↓
Liabilities Lp ⇑
Capital goods Kp ⇑
Net wealth Wp
Table 2: Balance sheets of the Fed (a), the Treasury (b) and consumers (c)
appreciation of the yuan which has taken place in the meantime, as depicted in ﬁgure
1(a), the trade ﬂows which are part of the current account can be considered of even
Similar observations can be made for the creation of domestic credit (including credit
to the government, ﬁnancial institutions and the non-ﬁnancial sectors) and changes in
foreign exchange (FX) reserves, shown in ﬁgures 1(b) and 1(c). Both have increased
considerably in line with the argument laid out in the preceding chapter. Since these
stylised fact only hint at the argument being supported by the data, it remains to be
veriﬁed using a fully formulated model and the respective econometric analysis. Only
these two can deliver the degree of accuracy needed to answer the question.
3 Savings-Investment Imbalances
According to Keynes (1936), business cycles are driven by investment.15
capital markets and those for goods and services are connected via investment. Depending
on the valuation of ﬁnancial assets, investment projects are started, postponed or called
oﬀ. Investment projects that after completition may be sold for a proﬁt are easier to
15 cf. ch. 22, II.
(a) Change in net foreign assets
(b) Change in domestic credit
(c) Change in FX reserves
Figure 1: Smoothed changes in monetary variables and comparison with exchange rate
developments (a), (b) and (c).
Source: PBC, Monetary Survey
ﬁnance and more likely to be started.16 In addition, investment can be aﬀected by the
way ﬁrms are ﬁnanced. Minsky (1982) distinguishes three modes of external ﬁnance:
hedge ﬁnance, speculative ﬁnance and Ponzi ﬁnance. Given some shared thoughts about
the acceptable level of debt and expectations about the future, ﬁrms decide how to ﬁnance
their businesses. The more ﬁrms engage in speculative and Ponzi ﬁnance, the more likely
a debt-deﬂation process becomes when the next downturn arrives.17
The cause of positive savings-investment imbalances is overinvestment in the preceding
periods.18 Imagine a two-sector economy with a sector producing investment goods and
another producing consumption goods. The latter sector buys the former’s products,
with prices dependent on supply and demand, which themselves depend on the size of the
respective sectors. On the supply side, savings are needed to ﬁnance the production of
investment goods. However, more savings mean less consumption, which diminishes the
demand for investment goods. Therefore, there is a delicate balance between the sectors
which has to be maintained. If savings are too high, there is too much investment and not
enough demand for investment goods, while if savings are too low, supply of investment
goods is not suﬃcient to satisfy demand. The former possibility leads to deﬂationary
tendencies, while the latter leads to inﬂationary tendencies.
The size of savings-investment imbalances depends on the size of available savings
and investments. In autarchy, there is a domestic limit to savings. In an integrated world
economy with quite extensive ﬂows of capital, saving-investment imbalances can get much
bigger. Just by how much depends on the international economic order. Lately, current
economic imbalances have been justiﬁed by a theory promoting the so-called Bretton
Woods II system.19 In consequence, capital was ﬂowing from poor countries to a rich
country – the US – for most of this decade. Although we highlight the inﬂuence of the
Chinese growth strategy here, it is not the single cause of this allocation of capital. Other
countries are net exporters as well.20 Some were not able to spend the acquired US dollars
or exchange them into domestic currency in order to buy local ﬁnancial assets, so they
have done their part. However, the sheer size of US dollar-denominated assets held by
the Chinese government has led us to focus on China.
Piling up foreign assets has reached new dimensions in the years before the crisis.
China now holds almost one quarter of US government debt.21 We argue that this has
led to distortions and crowding out in the US ﬁnancial market. Figure 2 depicts the US
16 See Casalin and Dia (2009) for an evaluation of Tobin (1969). For intuition, think of ship-building.
In a climate of rising prices for ships it will be easier to get loans for ship construction, since they act
as a collateral for the bank.
17 See von Peter (2005).
18 This was ﬁrst brought to prominence by the Austrian school of economics.
19 See Dooley, Folkerts-Landau, and Garber (2004) and more recently Dooley, Folkerts-Landau, and
20 These are Germany, Japan and the oil-exporting economies.
Figure 2: US capital market (left) and US money market (right)
capital market (left) and the money market (right). In equilibrium we have an interest
rate which mirrors the natural rate of interest in line with Wicksell (1898, p. 150 and
XI) and modern inﬂation-targeting.
The additional demand from China for US
government debt would increase the asset’s price, if that asset’s supply was held constant;
otherwise yields on US debt would be driven down – however, this development has not
taken place. Public debt increased due to the Bush administration’s temporary tax cuts
and increases in military expenses (Frankel 2006). In the money market conditions were
also quite loose. The interest rate was lowered to ﬁght unemployment left from the 2001
recession. Against all odds, no large rise in inﬂation followed from both these policies.22
This can be seen in Figure 3. The black line depicts US consumer price inﬂation, the blue
line shows the yield on three-months treasury bills.
It is astonishing that the yield of the (supposedly) riskless asset lies below the US
inﬂation rate. This means that whoever is saving by holding US government bonds while
living in the US is losing purchasing power. In Keynes’ words this situation translates
into a negative prospective yield of the investment or, in terms of savings, ”if, therefore,
an act of saving does nothing to improve prospective yield, it does nothing to stimulate
investment”.23 Hence, holding government bonds is not a good vehicle for saving since
the real interest rate is negative—good times for borrowers, bad times for savers. One
would expect that at the moment it becomes clear that US government bond yield will
stay below the inﬂation rate for some time, savers looked for other investments. Besides
government debt, money is invested mostly in private ﬁrms via the stock market or in
real estate. We therefore expect that the crowding-out of US savers in the market for
government debt leads to a partial ﬂow of capital into the remaining domestic options:
real estate and the stock market.24
22 This is the missing inﬂation puzzle. For further readings on this topic see Leijonhufvud (2007).
23 The aspect of investment is dealt with in ch. 11 of Keynes (1936, p. 135) while the connection with
savings is made in ch. 16, p. 212.
24 The theory of portfolio diversiﬁcation states that ceteris paribus one domestic asset category is re-