Making sense of China’s astronomical foreign reserves

The current global-imbalance literature (which explains why capital flows from poor to rich countries) cannot explain China?s foreign asset positions because capital cannot flow out of China under capital controls. A related but deeper puzzle that this literature fails to address is China?s high saving rate despite an astonishingly rapid income growth rate. This paper argues that understanding China?s massive foreign reserves must start with a basic trade model (e.g., Melitz, 2003) in which a growing trade volume is driven by an elastic labor supply and rapid productivity growth. Imbalanced trade will then emerge if there exist uninsured risks (which remain constant as the economy grows) and exporters are borrowing constrained. In this case, fast growth can lead to excessively high saving rates and trade surpluses. Thus, a modified Melitz model featuring rapid productivity growth, elastic labor supply, and incomplete markets can qualitatively and quantitatively explain China?s massive (and \"passive\") accumulation of low-yield foreign reserves. The simple infinite-horizon model is hence consistent with the stylized fact that high saving is the consequence of high growth instead of the opposite (Modigliani and Cao, 2004), which the permanent income theory and global-imbalance literature fail to predict.