Global imbalances in the financial system had no small role in the financial crisis. And these imbalances haven’t disappeared.
China announced on Wednesday that its foreign exchange reserves had crossed the $2 trillion mark for the first time ever. In the middle of a global recession that’s hit this export economy badly, reserves rose $185.6 billion in the first half of 2009. What gives? During the same period, China has been reporting a shrinking trade surplus, with foreign direct investment down too.
That leaves short-term capital flows, or “hot money”. The size of these flows is anyone’s guess; but if the 75% gains on the Shanghai stock market this year are any guide, investors are flocking to an economy still roaring. But these flows, in turn, may persuade China to increase dollar holdings and finance US deficits.
And China is not the only attractive emerging economy. India found itself in a position recently where short-term capital overheated the system. With foreign flows regaining strength, it may happen again.