Dynamic Effects of Foreign Direct Investment on the Current Account: A DGE Analysis with Technology Transfer

This research develops a two-country dynamic general equilibrium (DGE) model on foreign direct investment (FDI) with endogenous technology transfer to analyze their effects on the current account. While China’s huge current account surplus is often attributed to the artificial undervaluation of Reminbi (RMB) and the lack of flexibility in the exchange rate, this paper argues that the large current account surplus is endogenously generated by the rapid growth in productivity, domestic fixed investment and, in particular, FDI.Empirical findings in the literature (e.g. Glick and Rogoff, 1995; Gregory and Head, 1999; Iscan, 1999; Decressin and Disyatat, 2008) generally find that permanent productivity or monetary shocks have negative effects on the current account (i.e. increase the trade deficits) for developed countries, but this contradicts the recent experience of China in terms of its current account dynamics. This observed inconsistency between the model predictions in the literature and the experience of China indicates that China may be subjected to some other shocks on top of, or other than, the productivity and monetary shocks.In the DGE model, the researchers incorporate two unique types of shocks commonly experienced by emerging countries, namely, high growth in domestic and foreign direct investment. The effect of FDI on the current account is expected to be even more pronounced than that of the domestic fixed investment as FDI raises the production capability not only through capital accumulation but also through technology transfer. To anticipate the results, a positive permanent FDI shock is expected to generate positive intertemporal impacts on the trade surplus as a result of the expansion of production capacity over time, and it possibly has a substitution effect on import as well.To illustrate the applicability of our model, the researchers calibrate it based on the major features of China. The theoretical framework is expected to provide an equilibrium explanation for the dramatic increase in China’s trade surplus during 2004-2007, which led to the rising appreciation pressure on Renminbi (RMB).