East Asia and Global Imbalances: Saving, Investment, and Financial Development Menzie Chinn University of Wisconsin and NBER Hiro Ito Portland State University Presentation at the 2 nd Annual Open Macroeconomics and Development conference, Université de la Méditerranée CEDERS, July 2-3, 2007.

Motivation “… some of the key reasons for the large U.S. current account deficit are external to the United States,... Providing assistance to developing countries in strengthening their financial institutions … could … increase both the willingness of those countries to accept capital inflows and the willingness of foreigners to invest there. … Thus, we probably have little choice except to be patient as we work to create the conditions in which a greater share of global saving can be redirected away from the United States and toward the rest of the world - particularly the developing nations.” Bernanke (2005)

Global Imbalances Source: Figure 1.14, IMF, World Economic Outlook, Sept. 2006

What is the main cause of US current account deficits? Twin deficit hypothesis  public dissaving due to U.S. fiscal policy shift in 2001 Saving glut hypothesis  Excess net saving in East Asia  US comparative advantage in financial market development

Chinn and Ito (2007) A 1 %-point increase in the budget balance would increase the CA balance by 0.10 to 0.49 %-points for industrialized countries US CA deficit slightly underpredicted, E. Asian surplus slightly underpredicted. More FD leads to higher saving for countries with underdevelopment institutions and closed financial markets that includes most of East Asian EMGs FD reduces the level of CA, especially for non-U.S. IDCs and Asian EMGs, but that effect is achieved, not through a reduction in savings, but through increased levels of investment

What do we do in this paper? We undertake a closer look at the effect of FD on CA balances and the S-I determination by investigating The effect of different types of FD (e.g., banking, equity, or bond) Different dimensions of FD, such as size, degree of activity, and efficiency How FD interacts with financial openness and institutional development How/whether FD functions as a magnifier for the effect of budget balances

Findings Budget balances matter for IDCs when bond markets are incorporated Both credit to the private sector and stock market capitalization appear to be equally important determinants of CA behavior. Increases in the size of financial markets induce an increase in the CA balance in developing countries. However, because of nonlinearities incorporated into the specifications, this characterization is conditional Countries with highly developed financial markets could experience a smaller current account balance when they increase the level of financial openness

Empirical Approach Data span , 19 IDCs, 70 LDCs Use five year panels to focus on medium-term determinants Macro variables: BuS, initial NFA, per capita income, per capita income squared, income growth, TOT variability Demographics Structural/Policy: Trade, capital acct openness (Chinn-Ito), financial deepening All the variables, except for net foreign assets to GDP, are expressed as deviations from their GDP-weighted world mean

Empirical Model Dependent variables (y) = the CA balance, national saving, and investment

Measures of Financial Development, Financial Openness, Legal Development LEGAL = first principle component of Law and Order, Corruption and Bureaucratic Quality (Sourced from ICRG). KAOPEN = Chinn-Ito index, based upon the IMF’s Annual Report on Exchange Arrangements and Exchange Restrictions (AREAER)

Measures of Financial Development, Financial Openness, Legal Development FD: Financial development  SIZE = the sum of private credit creation (PCGDP) and stock market capitalization (SMKC), % of GDP  ACTIVENESS – stock market total value (SMTV, % of GDP), stock market turnover (SMTO)  EFFICIENCY – (INV)NETINT = bank’s net interest revenue as a share of its total assets  BOND MARKET – private bond market capitalization (PVBM) and public bond market capitalization (PBBM)

Table 1: Current Account Regressions with SIZE

Table 2: Current Account Regressions with SIZE, SMTO, and INVNETINT

Robustness Checks 2SLS analysis – instrument the SIZE variable with the determinants of financial development: inflation rate, legal origins, and regional dummies  Generally, qualitatively similar results. The estimation results for LDCs and EMGs get stronger

Robustness Checks (con’t) Repeat the exercise using a different FD measure  First principle component of private credit creation (PCGDP), stock market capitalization (SMKC), stock market total value (SMTV), private bond market capitalization (PVBM), public bond market capitalization (PBBM), inverted net interest rate margin (INVNETINT), and life insurance premium as a ratio to GDP (LIFEINS)  The results get stronger for LDCs and EMGs, but weaker for IDCs

Adjustment for Government-owned Financial Institutions PCGDP might be an inaccurate measure of FD In some economies, a large portion of financial intermediary is provided by public financial institutions (e.g., China)

Adjustment for Government-owned Financial Institutions (cont’d) Adjust PCGDP by following the procedure outlined by Bekaert et al. (2006)  Use the La Porta et al. (2002) estimates of the ratios of government ownership of banks, and interpolate data over our sample period Using the “adjusted” PCGDP, we reconstruct the SIZE variable (SIZE2A) and reestimate

Adjustment for Government-owned Financial Institutions (cont’d) Interestingly, the estimation results are intact

Table 3: Total Effects of a 10 % Point Increase in FD (SIZE) Cond’l on LEGAL and KAOPEN (in percentage points)

Table 4: Total Effects of a One Unit Increase in KAOPEN Cond’l on LEGAL and FD (in percentage points)

Table 5: The Impact of Public Bond Market Development in CA Regressions

Ending Thoughts Both credit to the private sector and stock market capitalization appear to be equally important determinants of CA behavior.

Ending Thoughts (cont’d) The effect of FD is contingent upon legal/institutional development and financial openness  EMG countries with lower levels of legal/inst. development could experience a worsening in CA while the deterioration is severe when the country is more financially open).  The CA worsening is due to a ↓ in NS and an ↑ in I

Ending Thoughts (cont’d) The effect of financial opening is contingent upon legal/institutional development and FD  Financial opening could induce EMG countries to experience a deterioration in CA balances esp. when they are characterized by highly developed financial markets

Ending Thoughts (cont’d) Budget balances matters for IDCs when bond markets are incorporated – the estimation results are consistent with the higher end of the range of 0.10 – 0.49 found in Chinn and Ito (2007)