The World Bank

Abstract: China in the past few years has emerged as a net foreign creditor on the international scene with net foreign assets slightly greater than zero percent of wealth. This is surprising given that China is a relatively poor country with a capital-labor ratio about one-fifth the world average and one-tenth the U.S. level. The main questions that we address are whether it makes economic sense for China to be a net creditor and how we see China’s net foreign asset position evolving over the next 20 years. We calibrate a theoretical model of international capital flows featuring diminishing returns, production risk, and sovereign risk. Our calibrations for China yield a predicted net foreign asset position of-17 percent of China’s wealth. We also estimate non-structural cross-country regressions of determinants of net foreign assets in which China is always a significant outlier with 5 to 7 percentage points more of net foreign assets relative to wealth than is predicted by its characteristics. China’s extensive capital controls can explain why its current net foreign asset position is far away from what is predicted by open-economy models and cross-country empirics. It seems reasonable to assume that China’s international financial integration will increase over time. We calibrate and predict different scenarios out to 2025. These scenarios are necessarily speculative, but it is interesting that they typically imply negative net foreign asset positions between 3 and 9 percent of wealth. What may be counter-intuitive for many policy-makers is that successful institutional reform and productivity growth are likely to lead to more negative net foreign asset positions than occurs with stagnation. Starting from China’s zero net foreign asset position, it would take current account deficits in the range of 2-5 percent of GDP to reach any of these future net foreign asset positions. These are not unreasonable deficits, but they require a large adjustment from the present 6 percent of GDP current account surplus