Financial repression in China and Global Economic Imbalances

We apply the old concept of financial repression, originally due to Mckinnon (1973) and Shaw (1973), to the Chinese financial system and argue that it might explain the country's current account surplus. In a two-country model, we show that financial repression in one country (China), modeled as a tax on domestic investment, would drive capital out and render its trading partner (US) with tax-arbitrage opportunity that is used to fund the latter's current-account deficit. Calibration demonstrate that the effect is quantitatively significant. In contrast to a common view, this intervention would decrease wages, employment and welfare in the financially-repressed country.