Policy Recommendations
East Asia’s Role in Resolving the New Global Imbalances
Drafted by
Masaru Yoshitomi, Li-Gang Liu, and Willem Thorbecke*
In collaboration with members of the NEAT Working Group on“Resolving New Global Imbalances in an Era of Asian Economic Integration”**
Sponsored by Research Institute of Economy, Trade and Industry (RIETI)Tokyo, Japan, 1 August 2005

Index of Contents
I.
II.

Introduction
The Nature of the New Global Imbalances
A. U.S. Current Account Deficits
B. East Asian Current Account Surpluses
III. The Sustainability of the New Global Imbalances
A. The Sustainability of U.S. Current Account Deficits
B. The Sustainability of Reserve Accumulation by Asian Central Banks
IV. Necessary External Adjustment Policies in the U.S.
V. East Asia’s Role in Resolving the Current Global Imbalances
A. Basic Rationales for Concerted Appreciations
1. Triangular Trading Patterns in East Asia
2. Complementary and Competitive Trade Relations in East Asia
B. The Appropriate Policy Mix for the Region
VI.
Conclusion
A1. Appendix: U.S. Current Account Deficit Sustainability______________________________________________________________________*Masaru Yoshitomi is President and Chief Research Officer at RIETI. Li-Gang Liu and Willem
Thorbecke are Senior Fellows at RIETI.
**Listed at the end of this report. Extremely valuable and constructive written comments by theWorking Group members are incorporated.

I. Introduction
The world economy hangs in a precarious balance. Because of a shortage ofdomestic saving relative to investment, the U.S. is running large current account deficits
of 6% of GDP. These account for three-quarters of the world sum of current accountdeficits or net global saving. Private capital inflows since 2002 have proved insufficient
to finance U.S. external deficits. The shortfall, which has been accompanied by adepreciation of the dollar, has been made up largely by Asian central banks.

Thisarrangement cannot be sustained indefinitely: if the U.S. saving shortage is notcorrected, the dollar could depreciate further.
A major counterpart of the huge U.S. external deficits has been external
surpluses in East Asian countries. 1 These surpluses emerged since 1997-98, at the sametime that large U.S. deficits developed. East Asian surpluses account for about 45% of
both the world sum of current account surpluses and of the U.S. global deficit.
Whereas the primary responsibility rests with the U.S. to resolve her own large deficit,
East Asia could play a significant role in the adjustment process.
The purpose of this policy recommendation is to identify the roles that both the
U.S. and East Asian countries can play in resolving the current global imbalances. To
do this, we first discuss the nature (Section II) and sustainability (Section III) of theimbalances. We then recommend necessary external adjustment policies for the U.S.
(Section IV). Finally, we consider the role that East Asia can play, acting in her own
interest, in rebalancing the global economy (Section V) and draw conclusions (Section
VI ).

1 In the paper, we take East Asia to include ASEAN countries plus China, Japan, and Korea.

1II. The Nature of the New Global Imbalances
A. U.S. Current Account Deficits
U.S. external imbalances were driven by a private investment boom during thelate 1990s, a drastic reversal of the fiscal balance from surplus to large deficit after therecession of 2000-01, and high consumer spending from 1997 to the present. All three
have contributed to the shortage of domestic saving relative to investment (i.e., the I-S
imbalances) and thus to current account deficits now equaling 6% of GDP. Private
capital inflows between 1997 and 2001 were sufficient to finance U.S. current accountdeficits, and the real effective exchange rate of the dollar appreciated 17%. Private
inflows since 2002, however, have fallen short of current account deficits and the realeffective exchange rate of the dollar depreciated 17% between January 2002 andDecember 2004. The dollar is now close to its average value over the past quarter
century.

B. East Asian Current Account Surpluses
While the U.S. current account balance deteriorated after 1997, current accountbalances in East Asia have either moved from deficit to surplus (in the case of crisis-hit
economies) or from surplus to larger surplus (in the case of non-crisis hit economies).
The Asian Capital Account Crisis of 1997-98 was followed by lower investment/GDP
ratios than saving/GDP ratios in crisis-hit countries until now, leading to large current
account surpluses that stand in sharp contrast to the deficits of the pre-crisis period.
Non-crisis Asian economies such as Singapore and Taiwan also exhibited similar drops
in investment/GDP ratios relative to saving/GDP ratios, causing current accountsurpluses to expand further.

In contrast, China continued to increase bothinvestment/GDP and saving/GDP ratios, maintaining relatively small surpluses as ashare of GDP.
2

Exchange rates in crisis-hit East Asian economies, after initially collapsing by
50% or so during the crisis, have been kept on average 15-20% below pre-crisis levels
through central bank intervention in foreign exchange markets. 2 Exchange rate
experience in non-crisis East Asian economies has been similar except for the case of

the Chinese currency, which remained unchanged at 8.2 RMB per dollar from 1994
until 20 July 2005. Even larger intervention in the region began in 2002 when the
aforementioned shortfall of private capital inflows relative to U.S. deficits triggered therecent dollar depreciation. Since 2002, about 40% of U.S. external deficits have been
financed by foreign (primarily Asian) central banks.
The objectives of Asian central banks in accumulating large quantities ofreserves have been: 1) to be prepared for another capital account crisis which would
drain foreign reserves due to massive reversals of short-term capital flows, and 2) tomaintain competitive exchange rates in order to sustain the export-oriented thrusts of
their economies. The first objective was more important immediately after the crisis,
and the second objective has been more important in recent years.

III. The Sustainability of the New Global Imbalances
The aforementioned new global imbalances are precarious because they may
prove unsustainable. The sustainability question can be divided into two parts: 1) thesustainability of large U.S. deficits, and 2) the sustainability of reserve accumulation
by Asian monetary authorities.

A. The Sustainability of U.S. Current Account Deficits
As the U.S. runs current account deficits it accumulates debt against the rest of
the world. The sustainability of these deficits can be judged by considering whether
2 See Analytical Appendix, Figure 4.

3

foreign investors will willingly hold the amount of debt that the U.S. must issue tofinance her continued deficits. This analysis should take into account dynamic changes
in interest rates and risk premia on U.S. liabilities. Assuming that U.S. current accountdeficits continue to equal 6% of GDP and that the underlying U.S. nominal GDP growthrate equals 5% and that the net interest rate on net foreign liabilities remains negligible
as it is now, 3 net external debt will eventually reach 120% of GDP (6%÷5%) in the longrun. 4
These assumptions also imply that after 10 years net external debt will reach
65% of GDP, representing 18% of the wealth of the rest of the world. Such a level
might be willingly held by international investors and thus sustainable thanks partly to
the key currency status of the dollar.
However, interest rate dynamics get progressively worse over time. At present,
despite the fact that U.S. net external liabilities equaled 29% of GDP in 2004, net
international investment income remains slightly positive for the U.S. and thus the netinterest rate remains negative (hence favorable for the U.S.). This is because, up until
now, investment income earned by U.S. residents mainly from equity investments
including FDI abroad has exceeded investment income paid by U.S. residents mainly on
U.S. bonds held by the rest of the world. Even assuming that the current rates of returnon U.S. investments abroad and foreign investments in the U.S. remain unchanged, the3

The net nominal interest rate r is defined as net international investment income divided

by net U.S. external debt. Net international investment income is the difference between
international income received on gross U.S. assets held abroad and that paid on gross U.S.
external debt.
4

The following equation can be used to calculate the eventual value of U.S. liabilities

relative to U.S. GDP in the long run: n* = c/ (g-nir), where n* is the eventual level of net external
debt relative to GDP in the long run, c is the current account deficit relative to GDP, g is the nominal
growth rate of the economy, and nir is the net nominal interest rate on net U.S. external debt. Given theassumptions in the text, it implies that U.S. net external debt will reach 120% of GDP (6%÷5%).

4

massive amount of U.S. liabilities that are projected to accumulate over the next 10
years will raise the net interest rate to almost 1%. In this case the long run debt/GDP
ratio would be 150% of GDP (6%÷(5%-1%)), equal to 40% of the net wealth of the restof the world. 5
Notwithstanding the key currency status of the U.S. dollar, it is implausible that
foreign investors would hold such high shares (as exemplified above at 40%) of their
total wealth in U.S. assets without receiving a higher rate of return, especially if theyfeared that the dollar would depreciate. If after 10 years the required return on U.S.
assets rose by only 1%, the eventual debt/GDP ratio would be greater than 300% of
GDP (6%÷(5%-3%)). 6 This would exceed the total wealth of the U.S.! Thus current
borrowing levels in the U.S. will at some point prove to be unsustainable.
If current account deficits remained below 3% of GDP, on the other hand, theeventual debt/GDP ratio would remain below 60% of GDP in the long run, whichshould be sustainable, particularly given the key currency status of the U.S. dollar.

B. The Sustainability of Reserve Accumulation by Asian Central Banks
Foreign reserve accumulation by Asian monetary authorities increases basemoney and hence creates excess liquidity in the banking system. This in turn increases
the money supply and exacerbates inflation. To offset this, central banks in the region
have engaged in sterilization policies. Sterilization involves selling government bonds
or central bank bills to keep the monetary base unchanged and to mop up excess
liquidity in the banking system.
Sterilization policy in East Asia has so far been largely successful in preventing
money supply growth rates from accelerating. The CPI inflation rate has also remained5

See the Appendix to this report (Section A1).

6 See the Appendix to this report (Section A1).

5

low, between 1 to 3 percent per year.
However, there are still several difficulties associated with sterilization
operations. First, they cause commercial banks to hold more and more central bank bills,
eroding bank profitability and interfering with the allocation of credit through thebanking system. Second, sustained sterilization may fail in the long run because, as thestock of central bank bills or government securities grows large, interest rates on these
instruments may have to rise in order to induce investors to willingly hold them. Higher
interest rates would then attract further capital inflows and defeat the purpose ofsterilization (the self-defeating hypothesis). Third, continued accumulation of U.S.
Treasury securities (external reserves) results in an increasingly inefficient allocation of
resources since both private and social rates of return would be much higher forinvestments in the domestic economy.

IV. Necessary External Adjustment Policies in the U.S.
How should the U.S. respond to her own unsustainable external imbalances?
Since the large U.S. current account deficits originated from her own I-S imbalances
and account for three-quarters of total world deficits as already mentioned, the primary
responsibility for resolving global imbalances rests on the U.S. and her willingness toincrease national saving. 7

Increasing national saving would involve fiscal

consolidation and also policies to reduce consumption in order to raise householdsaving rates.

However, these absorption-reducing policies would be recessionary,particularly if such policies alone were assigned to external adjustment, and hence

7

The importance of increasing national saving is reinforced by the fact that the dollar in
2005, after having depreciated since 2002, is more or less at its long run average andthus not greatly misaligned. Nevertheless, the current account deficit remains huge.
This implies that U.S. external imbalances are being driven by shortfalls of saving
relative to investment in the U.S. and not by overvalued exchange rates
6should be offset by switching policies to stimulate net exports. Therefore a dollar
depreciation, which increases net exports by changing the terms of trade between
tradables and non-tradables in favor of the former, together with absorption-reducing
policies, could help to both achieve and maintain external and internal equilibria (i.e., asustainable current account balance and full employment with low inflation). If thedollar depreciated alone without any absorption-reducing policies, inflation could
accelerate. Thus the optimal policy mix for the U.S would involve fiscal consolidation
combined with a depreciation of the dollar.
If fiscal consolidation were not undertaken, however, market forces could drive
the dollar down in response to the rising share of U.S. assets in international investor
portfolios (i.e., the aforementioned unsustainable U.S. current account deficits). The
weaker the fiscal consolidation initiated, the more the dollar could fall. While thisdepreciation process might well be benign and gradual, there is a risk that it could be
sudden and precipitous.
Many studies indicate that, to reduce the U.S. current account deficit by 1% ofGDP, the dollar must depreciate by around 10%. 8

Thus, if fiscal consolidation is notundertaken, a 30% reduction in the value of the dollar would be required to reduce theU.S. current account deficit from its current value of 6% of GDP to the aforementioned
sustainable level of 3% of GDP. Thus a 30% depreciation can be taken as a working
hypothesis when considering policy recommendations for the risky scenario. Thisshould not be viewed as a prediction, nor can anyone reliably forecast the timing or
speed of a dollar depreciation.

V. East Asia’s Role in Resolving the Current Global Imbalances
A. Basic Rationales for Concerted Appreciations
8 Please see the Analytical Appendix, Section IV A, p. 17.

7

How should East Asian countries respond to the risky scenario of a 30%
depreciation of the dollar, as implied by the aforementioned working hypothesis?
Concerted action to maintain mutual exchange rate stability in the region would
be helpful for the following reasons:1) Since intra-regional trade accounts for about 55% of total trade, concerted increasesof East Asian currencies against the dollar would attenuate effective exchange ratechanges in the region. This in turn would mitigate the recessionary impact if Asiancurrencies appreciated against the dollar.
2) Exchange rate stability in the region would encourage continued FDI flows andprovide a stable backdrop for regional production and distribution networks whichhave been the basis for the high intra-regional trade share. By allowing fragmented
production blocks to be allocated across countries based on comparative advantage,these networks have acted as an engine of growth.

Of course, the comparativeadvantage of individual countries and thus these production networks themselves willchange dynamically over time.
3) It would help overcome prisoner’s dilemma problems that arise because the fear of
losing competitiveness relative to Asian trading partners sometimes prevents countries
in the region from allowing their currencies to appreciate. Ways of overcoming thesecoordination problems are discussed in Section V B.
We briefly discuss intra-regional trade patterns and prisoner’s dilemma problems
below before considering the appropriate policy mix for East Asia.

1. Triangular Trading Patterns in East Asia
A high degree of economic interdependence in East Asia, with intra-regional
trade accounting for 55% of total trade, is based upon intricate production and8distribution networks in the region that have led to triangular trade patterns. 9 Japan,
Korea, Taiwan, and multi-national corporations in ASEAN produce sophisticatedtechnology-intensive intermediate goods and capital goods and ship them to China forassembly by lower skilled workers. The finished products are then exported to markets
throughout the world. These processed exports account for 55% of China’s total exports.
The lion’s share of China’s processed exports is from FDI enterprises. Trade withinthese networks can be classified as vertical intra-industry trade (VIIT).
VIIT differs both from the exchange of final goods emphasized by traditional
trade theory for vertical inter-industry trade between the North and the South (e.g.,
between capital goods and apparel) and for horizontal intra-industry trade between the
North and the North (e.g., between two differentiated types of automobiles). VIIT
allows the production processes of an industry (e.g., the electronics industry) to be split
into fragmented production blocks that can be located in different countries. Production
blocks are allocated across developing, emerging, and developed economies in theregion based on comparative advantage as determined by relative endowments ofcapital, skill, and labor and by physical and institutional infrastructure. VIIT has led tolarge efficiency gains and helped to make East Asia as a whole the manufacturing centerof the world.
Because of these trading networks, Chinese value added in processed exports issmall (20%) relative to the predominant costs of the intermediate goods imported fromthe rest of Asia. Thus a unilateral RMB revaluation would not affect much the dollar
costs of processed final products and hence China’s trade surplus. Furthermore, in thetriangular trading patterns, China imports sophisticated intermediate goods essentially

9 FDI flows in East Asia have played an important role in strengthening the international

production networks, reducing costs, and transferring technological know how (SeeAnalytical Appendix, Section IV B 2, p. 20).

9

from East Asia but not from the U.S. and exports final products all over the world,
including to the U.S. Hence, these triangular trading patterns imply that bilateral tradeimbalances between China and the U.S. would remain large even if China’s global trade
surplus disappeared.

One policy implication that follows is that it is totally

inappropriate to demand a unilateral RMB appreciation simply because America’s
bilateral deficit with China is large.

2. Complementary and Competitive Trade Relations in East Asia
Because Asian countries compete with each other both domestically andparticularly in third markets, they may not follow regional partners in exchange rate
appreciations. As implied by the triangular trading patterns and by VIIT, relatively
more developed East Asian countries export large amounts of technology-intensive
capital and intermediate goods, while relatively less developed countries in the region
export large amounts of low skill-intensive consumer goods. Therefore there isessentially a complementary relationship between China and less developed Asia on the
one hand and developed Asia on the other hand in sophisticated intermediate and capital
goods trade. Furthermore, there is a complementary relationship between China and
MNCs located in ASEAN that export sophisticated technology-intensive parts andcomponents there for processing. In contrast, there is largely a competitive relationshipbetween China and less developed Asian countries in labor-intensive consumer goods
trade. Existing studies indicate that if one Asian country’s exchange rate appreciates
relative to other Asian countries’ exchange rates, that country’s exports (particularly oflabor-intensive consumptions goods) to third markets will fall. 10
All in all, elements of competition exist in any international trading relationshipand hence fear of losing competitiveness relative to other countries may prevent
10 See Analytical Appendix, Section IV B 4, p. 23.

10

individual countries from allowing their currencies to strengthen. This may explain theunwillingness of some countries in the region to allow their currencies to appreciateunilaterally. There could thus be a collective action problem or coordination failure: allcountries would be better off if their currency values increased together but individual
countries sometimes resist such increases because they are suspicious of whether othercountries will allow similar increases.

B. The Appropriate Policy Mix for the Region
In view of 1) the high ratio of intra-regional trade to total trade, 2) the intricate
production and distribution networks, and 3) the need to overcome coordination failures,concerted action to maintain mutual exchange rate stability among Asian currencies
could be beneficial. One form of concerted action would be for all countries in theregion to appreciate more or less jointly against the dollar under the aforementioned
working hypothesis. However, this concerted appreciation would not sufficiently take
into account individual differences among economies (e.g., policy options,macroeconomic variables, trade/GDP ratios, and structural factors) and would also
ignore the actual appreciations of some Asian currencies since 2002. How can thebenefits of concerted action be reconciled with the need to accommodate differences inindividual economic conditions?
Since concerted action is aimed at mutual exchange rate stability, currencies thathave not appreciated while the dollar fell between 2002 and 2005 should catch up withcurrencies that have already appreciated. This catch up would be achieved more easily
if countries in the region adopted more flexible exchange rate regimes.
More flexible regimes could be characterized by two elements: 1) a multiple
currency basket-based reference rate instead of a dollar-based central rate, and 2) a
wider band around the reference rate.
11

These two elements would provide policy makers with greater flexibility inmanaging the speed and magnitude of any necessary appreciation while still taking into
account their own individual economic conditions.
A free float would cause exchange rates to more accurately reflect market
fundamentals. However, given the shallow and narrow domestic capital markets insome East Asian economies, a free float for some countries would generate excessively
volatile exchange rates and harm economies in the region that are highly exposed tofluctuations in international trade.
We thus advocate, neither a free floating regime nor a fixed dollar peg but rather
greater exchange rate flexibility in the context of a multiple currency basket-basedreference rate with a band. If individual countries adopted greater flexibility in this way,
a dollar depreciation under the working hypothesis would tend to produce appreciations
across the region and keep mutual real effective exchange rates among Asian currencies
relatively stable.
Greater flexibility would benefit China for a couple of reasons. First, China will
begin to increasingly face de facto capital account convertibility with the free entry of
foreign banks and other financial institutions for renminbi-based financial activities dueto the terms of her WTO accession commitments. In this case wider bands would
enable her to maintain greater monetary policy autonomy in the face of volatile capital
flows.

Second, increased flexibility would provide Chinese banks and traders withexperience in managing exchange rate risk and allow Chinese forward markets andrelated infrastructure to develop quickly. At the same time China should purposefullybuild needed financial institutional infrastructure (e.g., prudential regulation,
supervision, accounting, a credit culture, etc.) as quickly as possible so that she canaccommodate greater flexibility in the very near future.
If Asian countries allowed their currencies to appreciate instead of accumulating12

reserves, it would have a recessionary impact. This could be offset by appropriate
macroeconomic and structural policies.

Switching policies such as exchange rate

appreciations thus need to be combined with absorption-increasing policies.
Absorption-increasing policies include employing fiscal and structural policies
to build both physical and human infrastructure (particularly in rural areas) and using
deregulation to promote competition and productivity growth in the non-tradable sector.
These policies could promote production for domestic markets and thus rely more on
domestic markets rather than exports to create jobs.
Combining expenditure-increasing policies with expenditure-switching policies
would thus be the appropriate policy mix for Asian countries that had previously
accumulated massive reserves. On the one hand, without exchange rate appreciations,policies aimed simply at increasing domestic demand could produce overheatedeconomies. On the other hand, without policies to increase domestic demand, exchange
rate appreciations would be contractionary. Only by combining these two, namely byimplementing an appropriate policy mix, could Asian economies move away fromexcessive reserve accumulation and simultaneously achieve external and internal
equilibria in their own interests. These policies would also contribute to easing global
imbalances, thus providing a harmonized way of advancing regional and international
interests.

VI. Conclusion
The present global imbalances cannot be sustained indefinitely. The primarystep necessary to resolve them is for the U.S. to increase domestic saving. Absent I-S
imbalance corrections in the U.S., the dollar could depreciate substantially due to theexcessive amount of dollar assets in the portfolios of international investors as
explained in Section IV. This decline could be gradual and benign, but it could also be
13

sudden and precipitous.
In the face of an incipient depreciation of the dollar as a risk scenario, Asian
countries ought to engage in concerted action to keep exchange rates as stable aspossible given their individual economic differences. This could be done if countries
with less flexible exchange rate regimes adopted more flexible regimes characterized bya multiple currency basket-based reference rate and a reasonably wide band. The
challenge for East Asian policy makers is to harmonize exchange rate policies in thisway.
Policy coordination to stabilize effective exchange rates mutually in the region
through selecting more flexible exchange rate regimes would provide several
advantages. First, concerted exchange rate changes against even a relatively large dropin the dollar’s value would reduce the magnitude of “effective” exchange rate increases
in East Asia, since about 55% of trade is intra-regional. This in turn would minimize
the deflationary effect of a rise in the value of Asian currencies against the dollar.
Second, exchange rate stability would facilitate the flow of FDI and preserve production
and distribution networks in the region that have exploited comparative advantage andfunctioned as an engine of growth.

These networks will change, though, as thecomparative advantage of countries change over time. Third, it should help overcome
prisoner’s dilemma problems that prevent individual countries from allowing theirexchange rates to rise unilaterally, even when joint increases would be mutually
beneficial.
Exchange rate increases should be accompanied by absorption-increasing
policies. These would offset the recessionary impact of the currency appreciations andalso be consistent with the new economic strategy in East Asia of encouraging domestic
demand rather than relying excessively on net export expansion.
In coordinating exchange rate policy a regional forum would be helpful. A
14

regional forum could develop the needed surveillance mechanisms and peer pressure in
the context of exchange rate coordination policies aimed at stabilizing mutual exchange
rates among East Asian economies, which would in turn promote continued economic
integration.
The coming East Asian Summit in Kuala Lumpur should be an appropriate
venue to begin discussing policy options along the lines spelled out here, in order toadvance the interests of countries in the region.

15

A1. Appendix: U.S. Current Account Deficit Sustainability

As the U.S. runs current account deficits it accumulates debt against the rest of
the world. One way to analyze the sustainability of these deficits is to calculate howmuch U.S. debt must eventually be held in the portfolios of international investors. This
analysis should take into account the evolution of interest rates and risk premia on U.S.
liabilities held by international investors. In order to understand the dynamic process
we start with the following simple equation to calculate the eventual value of U.S.
liabilities relative to U.S. GDP in the long run:(1)

n* = c/ (g-r)

where n* is the eventual level of net external debt relative to GDP in the long run, c isthe current account deficit relative to GDP, g is the nominal growth rate of the economy,
and r is the net nominal interest rate on net U.S. external debt. 11 Assuming that the U.S.
current account deficits continue to equal 6% of GDP and that the underlying U.S.
nominal GDP growth rate equals 5% and that the net interest rate on net foreign
liabilities remains negligible as it is now, equation (1) implies that net external debt willreach 120% of GDP (6%÷5%).

In addition, it can be shown that under theseassumptions, net external debt will reach 65% of GDP after 10 years.
U.S. net liabilities of 65% of U.S. GDP, which represents 18% of the wealth of
the rest of the world, might be willingly held by international investors and thus
sustainable. The fact that the U.S. dollar is a key currency implies that there is extra
demand for U.S. assets for transactions and precautionary purposes.
11

Given theThe net nominal interest rate r is defined as net international investment income

divided by net U.S. external debt. Net international investment income is the difference
between international income received on gross U.S. assets held abroad and that paid on
gross U.S. external debt.

16

hegemonic position of the U.S. and the key currency position of the dollar, investors
may be willing to hold this much U.S. debt.
The problem is that the interest rate dynamics get progressively worse over time.
At present, despite the fact that U.S. net external liabilities equaled 29% of GDP in 2004,
net international investment income remains slightly positive for the U.S. and thus the
net rate of return (r) on net foreign liabilities remains negative (hence favorable for theU.S.). This is because, up until now, investment income earned by U.S. residents fromabroad has exceeded investment income paid by U.S. residents to the rest of the world.
This has happened because U.S. assets from abroad are largely in the form of equities(including FDI), while U.S. external liabilities are largely in the form of fixed income
assets (including Treasury bills purchased by foreign central banks). Thus the average
return received by U.S. investors (3.9% in 2004) exceeds the average return received byforeign investors (2.6% in 2004) because the U.S. is holding riskier and more profitableassets.
Although r has been negative up until now, this will not be the case as the rest of
the world accumulates more U.S. liabilities. Even assuming that the rate of returnearned by the U.S. on foreign liabilities continues to exceed the rate of return earned by
the rest of the world on U.S. liabilities by the existing margins as mentioned above, thefact that the rest of the world is accumulating so many U.S. liabilities implies that after
10 years the net interest rate r on net liabilities will equal almost 1%. In this case thesteady state debt/GDP ratio implied by equation (1) would be 150% of GDP (6%÷(5%1%)). To put this number into perspective, if the rest of the world currently held U.S.
assets worth 150% of U.S. GDP they would be holding 40% of their total wealth in U.S.
assets.
It is implausible that even the extra demand for U.S. assets due to the key
currency status of the dollar would be enough to induce foreign investors to hold very17

high shares (as exemplified above at 40%) of their total wealth in U.S. assets without
receiving a higher rate of return. This would be true a fortiori if investors required arisk premium to guard against the chance that the dollar would depreciate. If after 10
years the required return on U.S. assets rose by only 1% from its current level of 2.6%,
the net interest rate r on net foreign liabilities would exceed 3%. 12 In this case theeventual debt/GDP ratio implied by equation (1) would be greater than 300% of GDP(6%÷(5%-3%)).

This would exceed the total wealth of the U.S.!

Thus current

borrowing levels in the U.S. will at some point prove to be unsustainable.
If current account deficits remained below 3% of GDP, on the other hand,equation (1) implies that the debt/GDP ratio would remain below 60% of GDP. 60% of
U.S. GDP represents 15% of the wealth of the rest of the world. Foreign investors may
be willing to hold this much of their wealth in U.S. assets without requiring an increasein the rate of return on dollar assets, given the hegemonic position of the U.S. and therole of the dollar as a key currency. In this case, the negative interest rate dynamics
discussed above would be less of a concern. Thus, U.S. current account deficits below
3% of GDP may prove sustainable.

12 The net interest rate r is (rUSROWUS- rROWUSROW)/(ROWUS - USROW), where rUS is theaverage rate of return that foreign investors earn on U.S. assets, ROWUS is the grossholding of U.S. assets by the rest of the world, rROW is the average rate of return that U.S.
investors earn on foreign assets, and U.S.ROW is the gross holding of foreign assets by U.S.
citizens. If USROW remains at its current value of 27% of U.S. GDP (YUS), then in 10 years
ROWUS will equal 0.92YUS (0.27 YUS + 0.65YUS ). If rUS increases from 2.6% to 3.6%, thenr would equal (0.036*0.92YUS - 0.039*0.27YUS )/0.650YUS . This expression equals 3.5%.

18

1st Meeting of NEAT Working Group on"Promoting Economic Integration in East Asia through Resolving Global Imbalances"on 14 December, 2004, at RIETI, Tokyo
List of Participants
China

Dr.He Fan

Assisting Director, Institute of World Economics and Politics
Chinese Academy of Social Sciences(CASS)

Indonesia

Dr.Raymond Atje

Head of the Department of Economics, Center for Strategic andInternational Studies

Korea

Dr.Jae-Ha Park

Senior Research Fellow, Financial System and Policy Division
Korea Institute of Finance

Dr.Sang-Yirl NAM

Research Fellow, Department of Trade and Investment Policy
Korea Institute for International Economic Policy (KIEP)

Malaysia

Dr.Azidin Wan Abdul Kadir

Research Fellow, Macroeconomic Trends and Forecasting
Division, Malaysian Institute of Economics Research (MIER)

ThailandDr.Piti Disyatat

Monetary Policy Analysis and Strategy Division, Monetary
Policy Group, Bank of Thailand

Dr.Masaru YOSHITOMI(Chairman)

President and Chief Research Officer, RIETI

Dr.Li-Gang LIU

Senior Research Fellow, RIETIDr.Masato HISATAKE

Senior Research Fellow, RIETI

Prof.Takatoshi ITOH

Faculty Fellow, RIETI/Professor, (Graduate School) Faculty of
Economics and Research Center for Advanced Science andTechnology, University of Tokyo

Prof.Kyoji FUKAO

Faculty Fellow, RIETI /Professor, Institute of Economic
Research, Hitotsubashi University

Prof.Shujiro URATA

Faculty Fellow, RIETI /Professor of International Economics
Graduate School of Asia-Pacific Studies Waseda University

Mr.Yoshiaki TOJO

Consulting Fellow, RIETI/Director, International Economic
Affairs Division, METI

Mr.Daisuke HIRATSUKA

Director, APEC Study Center/Director, Regional Integration
Studies Group, Interdisciplinary Studies Center, IDE-JETRO

Mr. Sozaburo OKAMATSU

Chairman, RIETI

Mr.Yasuo TANABE

Vice President, RIETI

Dr.Kazutomo IRIE

Director of Administration, RIETI

Mr.Yuji HOSOYA

Director of Research, RIETIJapan

Observer[Note] Due to the fact that this WG had been established before the rule for the enlistment of the WG members
was adopted at the Country Coordinators Meeting in Kuala Lumpur on 5 December,2004, the members of thisWG were enlisted not by the Country Coordinator of the country from which a member comes but by the
Research Institute of Economy, Trade and Industry (RIETI), which sponsored this WG.
19

2nd Meeting of NEAT Working Group on"Promoting Economic Integration in East Asia through Resolving Global Imbalances"on 11 April, 2005, at RIETI, Tokyo
List of Participants
China

Dr.He Fan

Assisting Director, Institute of World Economics and Politics,
Chinese Academy of Social Sciences(CASS)

Mr.Sjamsul Arifin

Acting Director, Center for Education and Central Banking
Studies, Bank Indonesia

Dr.Sang-yirl (Simon), NAM

Research Fellow, Department of Trade and Investment Policy
Korea Institute for International Economic Policy (KIEP)

Dr.Jae-Ha PARK

Senior Research Fellow. Financial System and Policy Division,
Korea Institute of Finance

Malaysia

Dr.Mohamed Ariff

Executive Director, Malaysian Institute of Economic Research(MIER)

ThailandDr.Piti Disyatat

Monetary Policy Analysis and Strategy Division, Monetary
Policy Group, Bank of Thailand

Dr.Kanit Sangsubhan

Director of Fiscal Policy Research Institute

Dr.Masaru YOSHITOMI(Chairman)

President and Chief Research Officer, RIETI

Dr.Li-Gang LIU

Senior Research Fellow, RIETI

Dr.Willem THORBECKE

Senior Research Fellow, RIETI

Prof.Takatoshi ITO

Faculty Fellow, RIETI / Professor, (Graduate School) Faculty of
Economics and Research Center for Advanced Science andTechnology, University of Tokyo

Prof.Eiji OGAWA

Faculty Fellow, RIETI / Professor of Hitotsubashi University,
Graduate School of Commerce and Management (International
Finance)

Mr.Yoshiaki TOJO

Consulting Fellow, RIETI / Director, International Economic
Affairs Division, METI

Prof.Kyoji FUKAO

Faculty Fellow, RIETI / Professor, Institute of Economic
Research, Hitotsubashi University

Mr.Nobiru ADACHI

Consulting Fellow / Director-general, Research Department,
Policy Research Institute, MOF

Mr. Sozaburo OKAMATSU

Chairman, RIETI

Mr.Yasuo TANABE

Vice President, RIETI

Dr.Kazutomo IRIE

Director of Administration, RIETI

Mr.Yuji HOSOYA

Director of Research, RIETI

Indonesia

Korea

Japan

Observer[Note] Due to the fact that this WG had been established before the rule for the enlistment of the WG members
was adopted at the Country Coordinators Meeting in Kuala Lumpur on 5 December,2004, the membersof this20
WG were enlisted not by the Country Coordinator of the country from which a member comes but by the
Research Institute of Economy, Trade and Industry (RIETI), which sponsored this WG.

3rd Meeting of NEAT Working Group on"Promoting Economic Integration in East Asia through Resolving Global Imbalances"on 25 July, 2005, at RIETI, Tokyo
List of Participants
China

Dr. Yu Yongding

Director of Institute of World Economics and Politics, CASS

Indonesia

Mr.Sjamsul Arifin

Acting Director, Center for Education and Central Banking
Studies, Bank Indonesia

Korea

Dr.Jae-Ha PARK

Senior Research Fellow. Financial System and Policy Division,
Korea Institute of Finance

Malaysia

Dr.Mohamed Ariff

Executive Director, Malaysian Institute of Economic Research(MIER)

Singpore

Dr.Tok Yoke Wang

Lead Anaylst, External Dept, Monetary Authority of Singapore

ThailandDr.Kanit Sangsubhan

Director of Fiscal Policy Research InstituteVietnamDr.BUI TRUONG GIANG

Research Fellow, Institute of World Economics and Politics
VIETNAM

Japan

Dr.Masaru YOSHITOMI(Chairman)

President and Chief Research Officer, RIETI

Dr.Li-Gang LIU

Senior Research Fellow, RIETI

Dr.Willem THORBECKE

Senior Research Fellow, RIETI

Prof.Takatoshi ITO

Faculty Fellow, RIETI / Professor, (Graduate School) Faculty of
Economics and Research Center for Advanced Science andTechnology, University of Tokyo

Prof.Eiji OGAWA

Faculty Fellow, RIETI / Professor of Hitotsubashi University,
Graduate School of Commerce and Management (International
Finance)Prof.Shujiro URATA

Faculty Fellow, RIETI /Professor of International Economics
Graduate School of Asia-Pacific Studies Waseda University

Mr.Yoshiaki TOJO

Consulting Fellow, RIETI / Director, International Economic
Affairs Division, METIMr.Takashi KIHARA

Consulting Fellow, RIETI

Mr. Sozaburo OKAMATSU

Chairman, RIETI

Mr.Yasuo TANABE

Vice President, RIETI

Dr.Kazutomo IRIE

Director of Administration, RIETI

Mr.Yuji HOSOYA

Director of Research, RIETI

Observer[Note] Due to the fact that this WG had been established before the rule for the enlistment of the WG members
was adopted at the Country Coordinators Meeting in Kuala Lumpur on 5 December,2004, the members of thisWG were enlisted not by the Country Coordinator of the country from which a member comes21but by the
Research Institute of Economy, Trade and Industry (RIETI), which sponsored this WG.