China s Imbalances : Trade Integration in a Dynamic General Equilibrium Model Preliminary June 2016

We study the factors that have led to both the large rise in Chinese gross trade ows and net trade ows, summarized by the large positive net foreign asset position, in a dynamic stochastic general equilibrium model of China and the Rest of the World with endogenous trade participation, pricing-to-market, aggregate uctuations, and incomplete nancial markets. The model features an endogenous time-varying trade elasticity from producer-level investments in export market access. We estimate the changes in technology, trade costs, and preferences accounting for the changes in Chinas gross and net trade ows, real gdp, and real exchange rate. We nd trade integration has proceeded in an uneven manner with a gap in the trade barriers between Chinese exports and imports opening and closing over time. Shocks to this gap are estimated to be persistent, but not permanent, providing a motive for intertemporal trade and thus account for a substantial share of Chinas accumulated net foreign assets in 2014. We also nd that the stagnation in trade growth since 2010 to primarily reect the completed transition to past trade reforms rather than increase in trade barriers. JEL classi cations: E31, F12. Keywords: Trade Balance, Real Exchange Rate, International Business Cycles. George.Alessandria@gmail.com; Horag.Choi@gmail.com; DanLv27@gmail.com. 1. Introduction Chinas economic growth and integration with the world economy has been an important and de ning economic event of the last twenty- ve years. It has been characterized by a substantial rise in income, a large increase in international trade, the accumulation of substantial net foreign assets, and important swings in the real exchange rate.1 Studies of the role of Chinese integration have generally been undertaken in static trade models with exogenous imbalances, and analyses of Chinese imbalances have often abstracted from gross trade ows and relative prices. Our main interest is in studying the joint determination of trade integration and trade imbalances. China has been growing fast for decades and yet despite this, it runs a current account surplus, accumulating a large stock of foreign assets. We study the sources of its growth, trade integration, and trade imbalances through the lens of a two-country dynamic stochastic general equilibrium model with incomplete asset markets, heterogeneous producers, and endogenous trade participation featuring a dynamic decision. We consider the role of persistent changes in trade barriers, technology, and preference. The preference shock a¤ects the discount factor and is designed to capture the often discussed Chinese "savings glut. " We estimate the process for these shocks using data on gross and net trade ows, the real exchange rate and output in China and the rest of the world, and the dynamics of producer-level export participation. Then we study the contribution of these shocks on the Chinese and world economy. In contrast to most analyses of Chinese trade integration, we focus on a model in which trade barriers make exporting an explicitly forward looking decision. The baseline model includes heterogenous producers facing trade costs that depend on their past export history as in Dixit (1989), Baldwin-Krugman (1988), Das, Roberts, and Tybout (2007), Alessandria and Choi (2007,14a,b) and Alessandria, Choi, and Ruhl (2014). These types of dynamic models have been shown to best explain producer level export participation as well as the dynamics of trade integration. The model allows for a di¤erent short-run and long-run trade elasticity and thus allows us to more accurately assess the sources of trade integration. The model is calibrated to capture some salient features of producer involvement in international Two striking features of Chinas economic growth over the last twenty years have been a sustained trade integration, with imports and exports expanding at roughly double the pace of economic activity, and large trade surpluses. For instance, Chinas share of US trade (exports and imports) has grown from 2.5 percent in 1992 to 10.6 percent in 2013. This growth has been unbalanced with Chinese exports to the US on average 3 times Chinese imports from the US. Indeed, China has grown from being a slight debtor to the rest of the world of about 5 percent of its GDP in 1992 to being creditor of about 21 percent of its GDP in 2011 (Lane and Milesi-Ferreti 2007).