Causes and Remedies of China’s External Imbalances

Chinas large current account surpluses not only destabilize its macroeconomic conditions but also are also at the center of global rebalancing. The literature offered five explanations for such surpluses, most of which are important but fail to account for the recent surge and/or offer actionable policy responses. In this study, we propose an alternative hypothesis for Chinas large current account surpluses: asymmetric market liberalization and associated cost distortions. This unique reform approach was the fundamental cause of both extraordinary growth performance and growing structural imbalances during the reform period. Indeed, estimates of cost distortions provide good fits of the current account. Estimated cost distortions rose after 2004 but peaked in 2006 at 12.2 percent of GDP. The worst of the external imbalance problem may be already behind us. We argue that, for rebalancing its economy, China needs a comprehensive package focusing on further liberalization of factor markets. Exchange rate policy should be an important part, but exclusive focus on the currency could be counterproductive.