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Deciphering China’s Puzzling Capital Flows

Economist Ellen McGrattan turns to theory to explain why China’s growth pattern defies expectations
June 13, 2016

“It’s hard not to be dazzled by China’s extremely rapid economic growth,” says Ellen McGrattan, professor of economics at the University of Minnesota. “But more interesting, is that they aren’t satisfied making the trinkets you’re buying at Walmart, they are ready to move to the technological frontier.” China is catching up to the US as a global producer in high-tech areas such as aerospace, semiconductors, and telecommunications, and is on a trajectory to be among the ranks of the advanced nations.

McGrattan is a macroeconomist interested in the aggregate effects of monetary and fiscal policy, such as impacts on GDP (gross domestic product), investment, the allocation of hours, the stock market, and international capital flows. Recently, she has been reexamining some puzzling scenarios in macroeconomics and international finance, including China’s the capital flows.

In the early 1990s, China experienced a surge in its inflow of foreign direct investment, as is expected in a quickly developing country. Advanced countries want what China has – access to a huge market – and advanced countries have what China wants – knowledge from accumulated R&D (research and developement), patents and brands. However, upon closer examination of the data, McGrattan found that only a small percentage of the foreign direct investment was coming from the US, Western European countries or Japan. If it wasn’t flowing in from advanced countries as theory would suggest, then where?

McGrattan decided to dig a little deeper into the data. Together with her coauthors Tom Holmes, professor of economics at the University of Minnesota, and Ed Prescott, professor of economics at Arizona State University, McGrattan looked at the microdata, studied the organizational arrangements of multinationals in China, and tracked individual patents to figure out why the country’s capital flows from advanced nations were so small. It turned out that 70% of China’s inflows and 66% of its outflows were to and from the United Kingdom Islands and Hong Kong in large part because foreign investment receives preferential tax treatment.

“So why then, weren’t advanced countries investing in China at the rate economists would expect?” asks McGrattan.

She found the answer in China’s quid pro quo policy. In certain industries, especially those that are high-tech, China requires foreign companies to conduct a joint venture and set up R&D centers in China. When these entities develop new patents and technology, the property rights for the Chinese partners are restricted to China. This transfer of technology mandated by China is the quid.

Companies, in turn, get market access, which is the quo.

McGrattan and her coauthors have found that this policy greatly benefits China at the expense of the advanced countries. China enjoys 5% more consumption each year while the US, Western Europe, and Japan’s consumption are reduced by .3-.5% per year. Furthermore, under this policy, China has accumulated 50% more capital while the US, EU countries, and Japan have lost 4-8%. While this arrangement negatively impacts multinational corporations, ultimately they still gain, and it is a tax they are willing to pay for market access.

“Economic theory is great,” says McGrattan. “It helps us organize the facts and analyze the impact of different policies. The data about capital flows were at first puzzling, but theory helps us understand that under quid pro quo, the data actually make sense.”

View McGrattan's presentation at the Heller-Hurwicz Economics Institute spring roundtable.

This story was written by Xinyao Qu, an undergraduate student account executive in CLAgency. Meet the team.