FRBSF Economic
Letter
2007-04; February 9, 2007
2006 Annual Pacific Basin Conference: Summary
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Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Studies within the FRBSF's Economic
Research Department.
This Economic Letter summarizes the papers
presented at the annual Pacific Basin Conference
held at the
Federal Reserve Bank of San Francisco on June 16-17,
2006, under the sponsorship of the Bank's Center for
Pacific Basin Studies. The papers are listed at the
end and are available online.
This year's Pacific Basin conference brought together
ten papers on a variety of international topics,
including the determinants of the U.S. current account
deficit,
the interest rate parity puzzle, monetary integration
in East Asia, and other developments in Asia.
U.S. current account deficit
The rising current account deficit in the U.S., now
running at about 7% of GDP, has attracted considerable
attention in recent years. Two papers at the conference
analyzed the determinants of the U.S. current account
position.
Charles Engel of the University of Wisconsin and
John H. Rogers at the Board of Governors of the Federal
Reserve System investigate the possibility that the
U.S. current account deficit, large as it is, may
nonetheless
be the outcome of optimizing behavior. They develop
a simple model in which a country's current account
is determined by the expected discounted present
value of its future share of world GDP relative to
its current
share of world GDP. They show that higher expected
output growth in the U.S. relative to that abroad
can generate large deficits, as the high U.S. output
path
supports increased lending from foreigners with which
to finance these deficits. Moreover, under reasonable
assumptions about future U.S. GDP growth relative
to other countries, a high U.S. current account deficit
may be sustainable for some time to come. Correspondingly,
they foresee little depreciation of the real value
of the dollar in the near term, though this conclusion
is sensitive to assumptions about tastes and technology.
Michael Devereux, Amartya Lahiri, and Ke Pang at
the University of British Columbia try to throw light
on
the value of different explanations for the U.S. current
account deficit. For instance, it may reflect higher
underlying productivity growth in the U.S., as Engel
and Rogers argue, or it may simply reflect a trend
increase in U.S. consumption and fall in saving, independent
of the path of productivity. To identify the determinants
of the deficit, Devereux et al. use a standard two-country
general equilibrium model and obtain quantitative estimates
of various "wedges," that is, the extent
to which various relationships associated with the
model, such as the conditions for optimal consumption,
employment, investment, and production, deviate from
actual data. They then feed each of these measured
wedges into the model and simulate the counterfactual
path of the current account in order to determine the
contributions of each to the overall external imbalance
of the U.S. They find that a combination of higher
U.S. productivity and consumption than abroad does
the best job in accounting for most of the measured
movement of the U.S. current account.
Interest rate parity
The uncovered interest rate parity equation relationship
is a cornerstone of most models in international
macroeconomics. This relation predicts that a country
with an interest
rate higher than abroad should be associated with
expected depreciation of its currency in order to equalize
the
returns to investing in foreign versus domestic assets.
In fact, it has long been a puzzle why this relation
does not hold empirically, in that relatively higher
domestic interest rates have been found to be followed
by ongoing currency appreciations.
Philippe Bacchetta of the University of Lausanne
and Eric van Wincoop at the University of Virginia
investigate
the extent to which incomplete information processing
by financial investors can explain this puzzle. Most
models assume that all investors instantaneously
incorporate all new information into their portfolio
decisions.
The authors consider two forms of incomplete information
processing: (i) infrequent portfolio adjustment by
investors, where investors make changes in their
portfolios slowly over time, and (ii) partial information
processing,
where investors use only a subset of all available
information. They argue that evidence on the costs
of portfolio management can justify such incomplete
processing behavior and that it explains the interest
parity puzzle. In their framework, an increase in
the domestic interest rate leads to an increase in
demand
for the domestic currency and therefore an initial
appreciation of the currency as well. But when investors
make infrequent portfolio decisions based on limited
information, they will continue to buy the currency
as time goes on. This can cause a continuing appreciation
of the currency.
China growth and trade balance
Since 1978 China's GDP has grown almost 10% per year,
while its GDP per capita has grown almost 6% annually.
At the same time, there has been a noticeable transformation
of the economy, with the share of workers in agriculture
decreasing from over 70% to less than 50%.
Robert Dekle and Guillaume Vandenbroucke at the University
of Southern California formulate a quantitative,
general equilibrium growth model to try to capture
China's
recent growth and structural transformation. Their
model distinguishes three sectors: the agricultural
sector, the nonagricultural private sector, and the
nonagricultural public (government) sector. They
use this model to measure the relative contributions
of
productivity improvements and the transfer of labor
out of agriculture into high-productivity activities.
They find that between 1978 and 1995 the reallocation
of labor from agriculture to nonagriculture accounted
for over one-third of China's average annual increase
in output per capita (that is, 2.0 percentage points
of total labor productivity growth of 5.2%), while
productivity growth in the public sector and private
nonagricultural sector contributed 1.6 and 0.6 percentage
points, respectively. Over the more recent period
1996-2003, however, the reallocation of labor from
the public
to the private nonagricultural sector accounted for
a significant part of growth, contributing 1 percentage
point of total labor productivity growth of 5.8%
per year, while public and private nonagricultural
sector
productivity growth contributed 1.0 and 2.7 percentage
points, respectively.
China's current account surplus as a percent of GDP
rose from 2.4% in 2002 to 7.2% in 2005 and is on
pace to rise even higher in 2006. Some have attributed
this
development to an undervalued currency that makes
Chinese goods unduly cheap in world markets, such as
the United
States. However, it is unclear how much even a substantial
appreciation of the renminbi would work to reduce
China's trade imbalance.
Jaime Marquez and John Schindler at the Board of
Governors analyze the response of China's trade to
a change in
the renminbi's value. They first point out that such
an exercise is hampered by two factors: first, the
data available on the prices of China's traded goods
are limited, and, second, the estimation sample includes
the period of China's transformation from a centrally
planned economy to a market-oriented system. To address
these limitations, they use a more sensible sample
period (1997-2004), and assess the impact of changes
in the real effective value of the renminbi on the
shares of China's exports and imports in world trade,
thereby avoiding the need for trade price proxies
to compute quantity measures of trade. Marquez and
Schindler
develop an empirical model explaining the shares
of China's exports and imports in world trade in terms
of the real effective value of the renminbi. The
estimation
results suggest that a 10% real appreciation of the
renminbi lowers the share of aggregate Chinese exports
by a half of a percentage point. The same appreciation
lowers the share of aggregate imports by about a
tenth of a percentage point.
Monetary integration in Asia
Three panelists discussed monetary integration in
East Asia. Many countries in East Asia are planning
or negotiating
regional trade agreements, and there is increasing
interest in financial integration and a common currency.
Peter Kenen at the Council on Foreign Relations and
Princeton University and Ellen Meade at American
University describe the history of increasing monetary
integration
within the region since the Asia financial crisis,
as well as policy options ahead, ranging from independently
floating currencies to a monetary union. They argue
that an Asian monetary union is unlikely to span
the whole region, primarily because of the continued
lack
of willingness to promote formal delegation of national
authority to common institutions. They foresee that
China and Japan, as the largest countries in the
region, are likely to keep their national currencies,
while
the ASEAN countries or a subset of its members might
be able to form a monetary union of their own. Peter
Petri of Brandeis University shows that East Asia
interdependence, defined as the preference for trade
among regional
partners, actually fell in the 1980s, but has been
growing in the last decade. He points out that most
of this increasing interdependence is attributable
to trade relationships fostered by greater specialization
in production.
Philip Lane of Trinity College in Dublin and Sergio
Schmukler at the World Bank highlight several features
that characterize the international financial integration
of China and India. First, these countries are large
holders of official reserves, while having only a
small global share of privately held external assets
and
liabilities (with the exception of China's foreign
direct investment liabilities). Second, their international
balance sheets are highly asymmetric: both countries
primarily hold low-return foreign reserves on the
asset side, together with higher-yielding equity and
debt
liabilities. Third, China and India have improved
their net external positions over the last decade,
although,
based on their level of economic development, neoclassical
models would predict them to be large net borrowers.
Lane and Schmukler project that domestic financial
reforms and capital account liberalization in both
countries will lead them to restructure their international
balance sheets and become major international investors,
with important consequences for global private financial
markets.
Other developments in Asia
R. Anton Braun at the University of Tokyo, Daisuke
Ikeda at the Bank of Japan, and Douglas Joines at
the University of Southern California investigate the
explanation
for recent declines in Japanese saving rates and
interest rates. They consider several explanations,
including
changes in fertility rates, changes in survival rates,
and changes in technology. They explore the empirical
relevance of these factors using a computable dynamic
overlapping generations model. They find that the
combined effects of an aging population and slower
total factor
productivity growth successfully explain the declines
in Japan's saving rate and after-tax real interest
rate during the 1990s.
David Cook at the Hong Kong University of Science
and Technology and Hiromi Nosaka at Kansai University
analyze
the behavior of labor markets in Indonesia at the
time of the 1997-1998 Asia crisis. They try to explain
why
output in Indonesia (and other affected countries
as well) fell, even as employment remained relatively
constant during the crisis. They do so with a dynamic
general equilibrium model of a small open developing
economy in which labor markets include both urban
employment
and rural employment. They show how an external financial
shock can lead to migration of labor from the productive
urban sector of the economy to the less productive
rural sector, leaving overall employment unchanged
even as aggregate output declines. Reuven Glick
Group Vice President
Conference Papers
Bacchetta, Philippe, and Eric van Wincoop. "Incomplete
Information Processing: A Solution to the Forward Discount
Puzzle."
Braun, R. Anton, Daisuke Ikeda, and Douglas Joines. "Saving
and Interest Rates in Japan: Why They Have Fallen and
Why They Will Remain Low."
Cook, David, and Hiromi Nosaka. "Dual Labor Markets
and Business Cycles."
Dekle, Robert, and Guillaume Vandenbroucke. "A
Quantitative Analysis of China's Structural Transformation."
Devereux, Michael, Amartya Lahiri, and Ke Pang. "Global
Current Account Adjustment: A Decomposition."
Engel, Charles, and John H. Rogers "The U.S. Current
Account Deficit and the Expected Share of World Output."
Kenen, Peter, and Ellen Meade. "Monetary Integration
in East Asia: Why East Asia Is Different and Why That
Matters."
Lane, Philip, and Sergio Schmukler. "The International
Financial Integration of China and India."
Marquez, Jaime, and John Schindler. "Exchange-Rate
Effects on China's Trade: An Interim Report."
Petri, Peter. "Is East Asia Becoming More Interdependent?"
Opinions expressed in this newsletter do not necessarily
reflect the views of the management of the Federal
Reserve Bank of San Francisco or of the Board of
Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
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