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rate, the real exchange rate is determined
by economic forces and not by government
intervention. Second, current account
surplus also exists in many other
emerging countries with a flexible
exchange rate, so it suggests that an
account surplus is caused by other
reasons. Third, we showed that financial
frictions can quantitatively explain a large
current account surplus in our model.
“Due to financial frictions, China
is lending money to the US at very low
interest rates, for example through US
Treasury Bonds. But the Chinese debt
repayment is very high in foreign direct
investment.” Since FDI earns a much
higher rate of return than bonds,
China always receives negative net
income payments. Thus, the country
needs to export more than it imports,
namely run a current surplus, to finance
negative net income payments.
and economic modeling. Prof Wang
challenged this outlook, theorizing that
asset bubbles are in fact driven by
sentiments of optimism and pessimism
rather than irrationality.
He and collaborator Prof Jianjun
Miao at Boston University developed a
new method to detect asset bubbles,
using a structured model in which
asset prices are derived from people’s
optimistic view and linked to real
variables, including stock prices and
investment in the economy. They
used US stock prices from 1985 to 2012
as the starting point. The period covered
the bursting of two major bubbles: the
internet bust of 2001, and the US
housing collapse of 2007. A basket
of economic data was analyzed,
including stock prices, consumption,
investment, hours worked, and the
relative price of investment goods.
Prof Wang has also used his theory
to analyze the housing bubble in China
and the effectiveness of policy to
dampen it. This includes assessing the
unintended consequences of moves to
increase stamp duty and limit purchases
to local residents.
“Credit-driven bubbles are very
fragile because optimistic belief can
turn to pessimism with a slight change
in the fundamentals. Asset prices drop,
credit gets crunched, lending and
liquidity evaporate, and investment and
consumption fall,” said Prof Wang.
His research has led him to believe
that if the bubble bursts in China, the
consequences could be more severe than
the collapse of the US housing market in
2007-08, making HKUST economists’
work in monitoring China’s emergence
all the more important.
Prof Wang’s theory suggests that, in
the long run, if China can improve its
banking-credit-financial system, house-
hold savings can be channeled more
effectively to its domestic production
sector. In addition, the greater availability
of credit for private enterprise would
allow the sector to expand, reducing the
role of FDI in production investment.
It could also assist in reducing the
liquidity that has helped fuel China’s
housing bubble.
This builds on Prof Wang’s earlier
work on asset bubbles, published in the
American Economic Review
(2012) and
Econometrica
(2013). Asset bubbles,
defined as the difference between
fundamental value and market value,
had previously only been studied on
the periphery of economics due to the
common assumption that they are
driven by irrational behavior that
does not lend itself to predictions
Prof Wang’s
work shows
how China’s
underdeveloped
financial system
explains the
capital flows in
and out of China
and its massive
trade imbalance
with the West.
capital is flowing from the US to China
in the form of Foreign Direct Investment
(FDI), which involves the investment
in a firm’s machinery and equipment.
This is because China has a higher rate
of return on fixed capital than the US –
consistently over 20% in recent decades.
“Many countries accuse China
of manipulating its exchange rate by
keeping it artificially low to generate
a huge current account surplus,” said
Prof Wang, whose findings, published
in
The Economic Journal
(2015), dismiss
currently popular political views. “We
argued this was not the case. First, it is
the real exchange rate, and not the
nominal exchange rate, that determines
the current account balance. While
China may adjust its nominal exchange
50%
of GDP
China’s total accumulated net
financial capital outflows
to developed countries in 2010
20%
of GDP
Accumulated net
FDI inflows
received by China from developed
countries in 2010
Capital flows (China vs US), % of China’s GDP
–
Outflow to US (Financial capital)
–
Inflow from US (FDI)
The orange line shows the accumulated
net FDI outflows from the US to
China as a percentage share of
China’s GDP; the blue line shows
the accumulated net financial capital
outflows from China to the US as
a percentage share of China’s GDP.
