In our discussions, we did not touch upon how the AIB might operate, and to what end. Let us assume that it indeed focuses on development finance in Asia. To what extent is that feasible?
The underlying premise of the AIB then must be that funds are scarce in the region, that the barrier to undertaking development projects, particularly infrastructure ones, is an issue of money rather than political will. So if China can mobilize its foreign reserves ($2+ trillion) to provide deposits, then the AIB can make a real dent in regional needs through its lending activities.
A focus on money can however obscure that such projects also require real resources. If indeed funds are scarce, then that implies that domestic savings in the region are insufficient. And if savings are low, then investment and consumption are using up corporate profits and personal income, and are not offset by governments running budget surpluses. In short, there is no excess on the domestic supply side, and the resources for projects must come from the outside. That in turn means that to relieve the constraint, AIB loans in the end serve to finance trade deficits.
So are such trade deficits feasible? Do the various countries in the region have low levels of international debt? Would loan terms be such as to provide long-term stable funding? Who would bear the foreign exchange risk – would the AIB lend in RMB or in local currency?
I’m skeptical that the international finance side will work; senior policymakers in the region surely remember the July 2, 1997 onset of the Asian Financial Crisis that trashed the economies of Thailand and Indonesia, and then later Korea, and hurt most others in the region. So they are likely reticent to borrow a lot (potentially offset by election dynamics where AIB loans could be used to finance highly visible projects that would make it tempting for politicians to go into hock). This is backed by empirical work, going back to a 1982 paper by Horioka and Feldstein, which found that domestic investment was closely correlated to domestic savings. in other words international finance was on average not important.
We’ll develop the following framework in class later this term. Start with two accounting identities:
Y = C + I + G + (X – M) and
C = Y – T – S
where the former is our normal GDP definition, and the later that consumption is income less taxes and savings. Then substitute the latter into the former: Y = Y – T – S + I + G + (X – M) and cancel out the Y’s and rearrange to get the open economy savings-investment identity:
(X – M) = (S – I) + (T – G)
In other words the trade balance is equal to the excess of savings over investment plus the excess of tax receipts over government purchases. Note this is an accounting statement, not a theory statement; it’s true as a result of how variables are defined. So if the government is already funding infrastructure, that is (T – G) is negative, and the economy is growing so that domestic savings is already being soaked up by domestic investment, so that (S – I) is zero, then the only way to further increase investment is by running a trade deficit.
That’s where the AIB would come in. Maybe. We could look at the case of successful developers – Japan, Korea, Germany, Italy – and ask whether international loans and aid were important in their cases. [Note: in 1960 Japan was the largest borrower from the World Bank, and tapped the IMF for emergency loans in 1961…but this was at a time when Japan was not viewed as creditworthy, and global capital markets were moribund so that private international loans were trivially small in all economies.]