Born like China, growing like China

• Date: 01 May 2019
• DOI: http://doi.org/10.1111/1468-0106.12258
• Published date: 01 May 2019
• Author: Xianjuan Chen

ORIGINAL MANUSCRIPT

Born like China, growing like China

Xianjuan Chen

School of Economics, Sichuan University,

Chengdu, China

Correspondence

Xianjuan Chen, School of Economics, Sichuan

University, 24 S 1st Section, 1st Ring Road

Wuhou, Chengdu, Sichuan 610065, China.

Email: zoeychen@scu.edu.cn

Abstract

This paper studies the effects of China’s one-child policy

on saving and foreign reserve accumulation. Fertility con-

trol increases the saving rate both by altering saving deci-

sions at the household level, and by altering the

demographic composition of the population at the aggre-

gate level. I show that demographically induced changes

in saving explain the build-up of a large foreign surplus in

China. As in Song, Storesletten, and Zilibtti (2011), the

model features contractual and financial market imperfec-

tions. Government-owned firms are less productive but

have full access to the credit market. Entrepreneurial firms

are more productive but face credit constraints. As labour

switches from less productive to more productive firms,

demand for domestic bank borrowing decreases. As saving

increases while demand for loans decreases, domestic sav-

ings are invested abroad, generating a foreign surplus. The

model predicts that China’s foreign reserve accumulation

will soon begin to slow down in response to recent relaxa-

tion of the one-child policy.

1|INTRODUCTION

In 1979 China introduced the so-called “one-child policy”, in an effort to reduce population growth

and improve economic conditions. This paper studies the effects of this policy on saving, investment

and foreign reserve accumulation. It constructs a dynamic overlapping generations model, calibrated

to match the unique demographic features of the Chinese experience. Echoing the results of Song,

Storesletten, and Zilibtti (2011), the model shows that China’s recent current account surpluses may

have nothing to do with exchange rate manipulation, but instead reflect the unique internal charac-

teristics of the Chinese economy. Unlike Song et al., however, I am able to explain the rapid rise in

China’s saving rate without appealing to exogenous changes in financial market regulations. Instead,

I show that it can be entirely explained by the one-child policy.

China’s household saving rate has been increasing at a rapid rate. The average urban household

saving rate rose steadily from 12.0% in the early 1980s to approximately 30% in 2010. The one-

child policy influenced saving at both aggregate and household levels. On the one hand, it shifted

Received: 26 January 2017 Revised: 25 July 2017 Accepted: 23 January 2018

DOI: 10.1111/1468-0106.12258

Pac Econ Rev. 2019;24:325–347. wileyonlinelibrary.com/journal/paer © 2018 John Wiley & Sons Australia, Ltd 325

China’s demographic composition, which influences the aggregate savings rate, even if household sav-

ing rates remain unchanged. At the same time, however, the one-child policy also impacted saving at

the household level. In countries like China, where the social pension system is not well established,

within-family intergenerational transfers are very important. Parents raise and educate their children

when they are young, and children financially support their parents when they retire. Intergenerational

transfers are not just based on cultural norms but are also stipulated by constitutionallaw. Children pro-

vide a crucial source of old age support in China. Thus, when exogenous fertility control is implemen-

ted, households’consumption and savingdecisions will be influenced. In addition to explainingChina’s

“saving puzzle”, the one-child policy canalso explain China’s“allocation puzzle”. Over the past couple

of decades, China has been experiencing rapid economic growth, sustained capital accumulation and a

growing foreign surplus. This combination is puzzling from the perspective of neoclassical growth the-

ory, which predicts that capital should flow from rich countries to poor countries. Based on this theory,

we should expect to see capital flow into China, given its rapid growth and poor initial economic condi-

tions (Lucas, 1990). Allowing for productivity differences across countries does not help to explain the

puzzle. If productivity levels are converging across countries, then the theory predicts that countries

experiencing relatively rapid convergence should be net international borrowers. The data indicate pre-

cisely the opposite (Gourinchas & Jeanne, 2013). In addition, Jeanne and Rancière (2011) and Bac-

chetta, Benhima, and Kalantzis (2013) found that neither the precautionary motive against aggregate

shocks nor the presence of idiosyncratic shocks can explaininternational reserve accumulation in China.

Wang, Weh, and Xu (2015) point to a “two way capital flow puzzle”: fixed capital flows from rich

to poor countries, whereas financial capital flows in the opposite direction. They augment a neoclassi-

cal growth model with two wedges: one that distorts firms’investment decisions and another that dis-

torts households’saving decisions. In this paper, I focus only on financial capital. I explain the puzzle

through investment and saving channels as well, but in a different setup. In the model of Wang

et al. (2015), the distortions on both the firm and household sides come from the borrowing con-

straints they are facing. They argue that severe financial frictions in poor countries create a price dif-

ference between the MPK and the real interest rate, both within and across countries. This gap in asset

returns drives the observed two-way capital flows. In contrast, the present paper argues that the puzzle

can be explained solely by internal economic adjustments. On the saving side, household savings

decisions are affected by fertility control, because parents shift their investment in the form of children

towards financial assets. However, in the model of Wang et al. (2015), a borrowing constraint and

exogenous preference shocks induce precautionary saving. Thus, the precautionary saving leads to

excessive household saving. Therefore, in this paper, I endogenize the observed change in household

saving. On the investment side, the borrowing constraint leads to resource reallocation within the

country, which decreases the demand for domestic loans. Because domestic saving increases while

demand for loans decreases, the excess savings flow abroad. Therefore, the present paper is also able

to explain the timing of foreign reserve accumulation.

In this paper, I show that demographically-induced changes in saving can explain the build-up

of a large foreign surplus in China. I borrow one key element from the model of Song et al. (2011).

Their model features financial and contractual imperfections that affect different types of firms

asymmetrically. There are two types of firms in their model, domestic private enterprises (DPE) and

state-owned enterprises (SOE). SOE are less productive but have better access to credit. DPE must

finance their investment through internal savings. I use this idea in my model to explain changes in

the domestic demand for loans. As capital in the DPE sector accumulates, labour switches from the

lower productivity SOE sector to the higher productivity DPE sector. As investment in the finan-

cially integrated SOE sector shrinks, demand for domestic bank borrowing decreases. Domestic sav-

ings are invested abroad, generating a foreign surplus.

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