A New Tri‐channel Decomposition of External Adjustment: Model and Application

• Published date: 01 July 2024
• Author: Wangyin Hu,Guangtao Xia,Yingting Li
• Date: 01 July 2024
• DOI: http://doi.org/10.1111/cwe.12541

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

China & World Economy / 68–84, Vol. 32, No. 4, 2024

68

A New Tri-channel Decomposition of External

Adjustment: Model and Application

Wangyin Hu, Guangtao Xia, Yingting Li*

Abstract

In this study, we expanded upon the current benchmark model of external adjustment and

dissected the concept of international financial adjustment into two distinct components:

valuation effect and investment income. Our enhanced model, which we refer to as “tri-

channel model,” incorporates three key elements: trade balance, valuation effect, and

investment income. Using a consolidated quarterly dataset that encompassed China’s

balance of payments and international investment positions from 1998 to 2020, we

estimated the relative importance of the three newly introduced adjustment channels to

China’s cyclical external imbalance. We found that the trade balance channel played

a major role, accounting for approximately 76 percent of cyclical external adjustment.

The contribution of the investment income channel to cyclical external adjustment

(21 percent) was much greater than that of the valuation effect channel (3 percent).

These findings imply that policy responses to the cyclical external imbalance in China

should focus more on the trade balance and investment incomes channels rather than

exploiting the valuation effects.

Keywords: external adjustment, investment income, trade balance, valuation effect

JEL codes: F20, F32, F41, G15

I. Introduction

In recent decades, the development of economic globalization has led to increasingly

polarized global external imbalances. Developed countries, like the US, have been

*Wangyin Hu, Lecturer, School of Economics and Finance, University of International Relations, China.

Email: huwangyin@uir.edu.cn; Guangtao Xia (corresponding author), Senior Research Fellow, Institute

of World Economics and Politics, Chinese Academy of Social Sciences, China. Email: xiagt@cass.org.cn;

Yingting Li, Researcher, Bank of China Research Institute, China. Email: yjylyt_hq@bank-of-china.com. The

authors appreciate the insightful comments and suggestions of editors and anonymous reviewers. Wangyin Hu

is grateful for financial support from Fundamental Research Funds for Central Universities, University of

International Relations (No. 3262024T23). Guangtao Xia thanks the Peak Strategy of Discipline Construction

of the Chinese Academy of Social Sciences (No. DF2023YS41) and the Laboratory of World Economic

Forecasting and Policy Simulation of the Institute of World Economics and Politics of the Chinese Academy

of Social Sciences (No. 2024SYZH003) for their f‌inancial support.

©2024 Institute of World Economics and Politics, Chinese Academy of Social Sciences

Tri-channel Decomposition of External Adjustment 69

running trade deficits for years, causing their net external debt-to-GDP ratio to rise. In

contrast, emerging economies, such as China, have accumulated large foreign exchange

reserves due to persistent current account surpluses.

Research on external imbalances dates back to the mid-18th century. The related

literature has shifted its focus from identifying long-term external imbalances to

investigating the optimal size of the imbalances. This shift can be traced from Hume’s

price specie-flow mechanism (1752) and the Keynesian school studies (Machlup,

1943; Meade, 1952; Metzler, 1960) to Mundell’s study of the optimal size of external

imbalances (Mundell, 1968). During the 1970s, the optimal growth model established

micro-foundations for macro-models of external imbalances. This allowed Hamada

(1969) and Bruno (1970) to examine how the consumption, saving, and investment

decisions of representative individuals impact a country’s external imbalance. Obstfeld

and Rogoff (1995) summarized previous research and presented an intertemporal

approach to the current account based on the life cycle permanent-income model. This

approach presents a significant advance in external adjustment theory, as it assumes

that changes in external net assets and current account balance are equivalent. In other

words, Obstfeld and Rogoff (1995) assumed that trade is the only source of change for a

country’s external wealth and neglect the impact of exchange rate fluctuation and asset

price volatility (Gourinchas and Rey, 2015).

In the 21st century, financial integration has led to increases in the scale of external

assets and liabilities, resulting in larger impacts of fluctuations in exchange rates and

asset prices on external adjustment. Many scholars have worked on this issue (Pavlova

and Rigobon, 2009; Corsetti and Konstantinou, 2012; Ghosh et al., 2019; Gustavo et al.,

2023). Meanwhile, there remains a significant gap between changes in the external

net assets and the current account balance, and even a negative correlation between

the two. This is inconsistent with the intertemporal approach to the current account

(Lane and Milesi-Ferretti, 2001, 2002). According to Devereux and Sutherland (2009),

when making an external adjustment for a country, it is important to consider not

only flow factors such as trade, but also changes in external market value caused by

fluctuations in exchange rates and asset prices, which are referred to as “valuation

effects.”

The emergence of the valuation effect provides a new perspective on the theory of

external adjustment. In addition to the traditional intertemporal approach, Gourinchas

and Rey’s (2007) dual-channel external imbalance adjustment model divides a country’s

external adjustment into trade and financial channels. These channels incorporate

information from both the trade balance (the flow) and the foreign asset position (the

stock). Several subsequent studies have used this dual-channel model as a benchmark