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Global Imbalances from Disaster RiskGlobal Imbalances from Disaster Risk.rar
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In the past two decades, China's holdings of US Treasuries have grown from less than 1% to
8% of US GDP, while the US trade deficit with China has reached 2% of GDP. In the same
period, Chinese TFP has been catching up to US TFP at a rate of 2% per year. Taken
together, these facts are at odds with the standard neoclassical growth model, which predicts
that capital should flow from the US to China. This paper argues that greater aggregate risk
in China can account for the observed trade deficit and debt holdings between the two
countries. This risk takes two forms: estimated TFP volatility and the potential of a rare drop
in TFP due to social unrest in China. Both sources of risk drive Chinese investors to engage
in decades-long flows of precautionary savings into the United States, quantitatively
dominating the effect of Chinese TFP catchup. Given that the Chinese Communist Party
takes the threat of social unrest very seriously, this is not a qualitatively unrealistic
mechanism. The contribution of this paper is to use a standard two-country growth model
with incomplete markets to show the size and frequency of the event that would result in the
observed flows. The event this paper finds sufficient, even with reasonably small values for
the coefficient of risk aversion, is one resulting in a disruption to Chinese GDP somewhat
larger than the Cultural Revolution but smaller than most "rare disasters" among developed
countries in the twentieth century.
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