Perspectives on Global Imbalances -- Remarks by Raghuram Rajan, Economic Counsellor and Director of Research Department, the International Monetary Fund
January 23, 2006Remarks by Raghuram Rajan, Economic Counsellor and Director of Research Department, the International Monetary Fund
At the Global Financial Imbalances Conference
London, United Kingdom
January 23, 2006
Good morning. Since this will be the first session on global imbalances, I thought I would give you a broad overview.1 [See Chart 1] The picture is familiar to most of you. The United States is running a current account deficit approaching 6 1/4 percent of its GDP this year and over 1.5 percent of world GDP. And to finance it, the United States needs to pull in 70 percent of all global capital flows. While the deficit is still increasing, the location of the surplus countries is changing. The current account surpluses of the oil-exporting countries of the Middle East have now surpassed those of emerging Asia, which were already quite high.
The current situation, I believe, has its roots in a series of crises over the last decade that were caused by excessive investment, such as the Japanese asset bubble, the crises in Emerging Asia and Latin America, and most recently, the IT bubble. [See Chart 2] Investment has fallen off sharply since, with only very cautious recovery. [See Chart 3] This is particularly true of emerging Asia and Japan.
The policy response to the slowdown in investment has differed across countries. In the industrial countries, accommodative policies such as expansionary budgets and low interest rates have led to consumption- or credit-fuelled growth, particularly in Anglo-Saxon countries. [See Chart 4]Government savings have fallen, especially in the U.S. and Japan, and household savings have virtually disappeared in some countries with housing booms.
By contrast, the crises were a wake-up call in a number of emerging market countries. Historically lax policies have been tightened, with some countries running primary fiscal surpluses for the first time, and most bringing down inflation through tight monetary policy. [See Chart 5] With corporations cautious about investing and governments prudent about expenditure—especially given the grandiose projects of the past—exports have led growth and savings have built up. Many emerging markets have run current account surpluses for the first time. In emerging Asia, a corollary has been to build up international reserves.
Some call this a new world order. I see the situation as a temporary but effective response to crisis. It is somewhat misleading to term this situation a "savings glut" for that would imply that countries running current account surpluses should reduce domestic incentives to save. But if the true problem is investment restraint, then a reduction in world savings incentives will engender excessively high real interest rates when the factors holding back investment dissipate. Put differently, I think it is best to see the underlying cause of current account surpluses as inadequate investment rather than excess savings, because the desirable policy response is to improve the investment environment rather than cut back on savings.
The world now needs two kinds of transitions. First, consumption has to give way smoothly to investment, as past excess capacity is worked off and as expansionary policies in industrial countries return to normal. Second, to reduce the current account imbalances that have built up, demand has to shift from countries running deficits to countries running surpluses.
The traditional view is that exchange rate movements will help guide these transitions. [See Chart 6] Since its peak in February 2002, the dollar has depreciated very markedly against the currencies of two of its major trading partners, Canada (27 percent) and the euro area (27 percent). In nominal effective terms, the decline of 13 percent is less marked but still large, which is why it is surprising it has not had a discernible impact on trade volumes. Of course, exchange rate movements will eventually have effect as firms that export to the United States are no longer able to maintain prices and absorb exchange rate losses. Importantly, it will help if all significant trading partners appreciate against the US so that US imports do not simply shift, directly or indirectly, from those countries that have taken the brunt of the appreciation so far to countries that have not. Nonetheless, given reasonably conservative elasticity assumptions, the depreciation to date would probably reduce the current account deficit over a period of several years by only about 1-1¼ percent of GDP.
But this is an "other-things-equal" calculation. [See Chart 7] What is not equal is the growth differential between the United States and its trading partners. The chart shows a well-known phenomenon: U.S. exports are more highly related to destination country GDP growth rates than to bilateral real exchange rates. [See Chart 8] For imports, the driving factor is U.S. domestic demand growth.
This means that while exchange rate depreciation will help shift demand, in general, however, such changes take time. The question is whether financial markets will be patient or force adjustments to occur through sharper price changes—notably exchange rates and asset prices—in a way that is destabilizing to the real economy and financial markets.
The most immediate concern in the current environment is whether foreign investors will continue to buy US assets without hiccups for the time it takes for the real side to adjust? [See Chart 9] Let us look at the composition of capital flows into the United States for some clues to the answer. Overall, the bulk of U.S. assets sold to foreigners are still to the private sector. This may come as a surprise to some of you who believe that the U.S. current account deficit is being financed by foreign central banks. The reality is that while the foreign official sector has increased its purchases, it still only amounts to less than one-third of the total inflows into the United States. So where is the rest going if, as was the case till recently, foreign central banks were putting in enough to nearly match the deficit? The answer is that it comes out again as US investors buy foreign assets.
It is therefore entirely correct to say the US current account deficit is more than fully financed by foreign private investors while U.S. private investment abroad is partly financed by foreign central bank investment in the United States. From the evidence we have so far, foreign central banks do not appear to vary their purchases of U.S. Treasuries in a systematic way with changes in the trade-weighted dollar, though it is true that the data are not perfect and we don't pick up foreign central bank activity when they funnel it through other countries' private institutions. Nonetheless, profits are less important to central banks, and they are less likely to make a rapid shift in the composition of their reserve portfolio. But before central banks turn decisively, foreign private investors who have no motive to buy dollars other than returns will have fled. It is they who are key to the financing of the US current account deficit.
Given this, it is worth noting that both foreign direct investment and net purchases of equities by non-residents have declined markedly since 2000. [See Chart 10] Foreign direct investment has staged a partial recovery since then, but remains below 1 percent of U.S. GDP. The decline coincides with a drop off in M&A activity in the United States and overleveraged balance sheets in the Euro area and Japan. At the same time, net purchases of fixed income securities have increased substantially, with most of the increase consisting of corporates and Treasuries. On net, therefore, the form of financing has become less favorable, even though there have been no serious problems so far. The concern is that financing will become more difficult—with consequences to U.S. interest rates and the exchange rate—precisely when other factors make the United States slow and look an unattractive place to invest, compounding the slowdown.
It is worth noting though that even if the dollar's depreciation has had little effect on the real side, it has had some stabilizing effects on the financial side. [See Chart 11] Since U.S. liabilities are denominated in dollars and its holdings of foreign assets are denominated in foreign currency, dollar depreciation reduces net U.S. liabilities, thus facilitating adjustment by sharing the burden among investors from other countries. It is notable that the valuation adjustments associated with the U.S. dollar depreciation during 2002-04 have offset a substantial part of the cumulative U.S. current account deficit over the same period. But as the dollar depreciated through 2004, foreign investors in the United States earned miserable returns on fixed income securities over the last few years, at least relative to domestic alternatives. While we saw a slight nominal appreciation of the dollar during 2005, the dollar may well depreciate again and investors may start demanding compensation, either by forcing a massive overshoot immediately so that anticipation of an appreciating dollar draws them back to U.S. assets, or by demanding higher rates. We cannot discount a run on the dollar entirely.
To summarize then, the global current account imbalances have arisen, in large measure as a temporary and uncoordinated response to crisis rather than as a permanent new (and perverse) international order. Emerging markets have recognized the risks posed by volatile cross-border flows, especially given the fragility of their own financial and corporate systems. They have learnt to fit their investment coat within the domestic savings cloth they have available, even leaving a bit over to finance rich countries. The resulting global liquidity, abetted by accommodative monetary and fiscal policies, has led to credit-fuelled housing and consumption booms in some developed countries, providing the needed global aggregate demand. And most recently, imbalances have been accentuated through the oil price boom and by countries resisting exchange rate appreciation. While the imbalances have been financed easily thus far, we cannot be sanguine about them.
The best case scenario is that demand shifts smoothly from deficit countries to surplus countries, even while aggregate world demand grows—the proverbial soft landing. There are two other possibilities. One is that as monetary and fiscal stimulus is withdrawn, consumption demand from the deficit countries, notably the United States, contracts sharply. Domestic demand from surplus countries does not keep pace, and even falls, because external demand has indirectly been pulling investment—for example, in the case of Germany or China. In this worst case scenario, we get a contraction of global demand, with only moderate correction of current account imbalances. A second possibility is that adjustment is forced by the financial side, because the real side is seen as unlikely to adjust on its own. Investors become unwilling to hold increasing amounts of U.S. financial assets, demand higher interest rates and some exchange rate overshooting, which in turn forces U.S. domestic demand to contract. Again, if this happens abruptly, it could cause a slow down, as well as financial market disruptions. Of course, overlaying all this is the specter of protection that could make things worse.
What can policy makers do to help effect the needed transitions? In developed economies running current account deficits, the policy emphasis should be on removing monetary and fiscal accommodation at a measured pace. The United States has agreed that reducing its fiscal deficit is part of the solution and is committed to reducing the deficit by half by 2009. While the goal is welcome, we believe the measures are not ambitious enough, and some revenue raising measures will have to be contemplated, especially in view of Hurricane Katrina and the Iraq war's effects on broader U.S. government spending.
Perhaps the central concern in the process of withdrawing accommodation has to be about consumption growth in the United States, which has been holding up the world economy. U.S consumption growth has to slow because the negative household savings rate is unsustainable. It will slow, perhaps on the back of slowing house price growth. The worry is that it will slow abruptly, taking away a major support from world demand before other supports are in place.
Turning to these other supports, there are some positive signs of increasing domestic demand in Japan and more mixed signals in Europe. More reforms are needed in both regions to spur growth. But what would especially help is more investment, especially in low-income countries, emerging markets, and oil producers.
The easy way to get more investment is a low-quality investment binge led by the government or fuelled by easy credit—emerging market countries are only too aware of the pitfall of that approach. [See Chart 12] The harder, and correct, way is through structural reforms that would improve the business environment, increase labor market flexibility, raise expected rates of return, and improve the allocation and utilization of capital by the financial and corporate sectors, all of which would promote more high-quality investment. This chart suggests there is scope for improvement, some of which is taking place.
Somewhat paradoxically, though, the favorable global economic environment and the resulting ability of many countries to rely on exports for growth have allowed their governments to not move further on the structural reforms that would have strengthened investment and helped sustain domestic demand. As a result, these countries are overly dependent on demand from other countries. This has to change.
China is different in that domestic demand looks increasingly insufficient, but not for want of investment. With the imbalances increasing, China's reserve build-up reaching enormous proportions, and China's current account surplus starting to grow significantly, it is in both the world and China's interest to allow the renminbi to appreciate more.
However, a huge step appreciation will probably do much more harm than good. For one, a number of the most efficient export oriented Chinese enterprises will be driven out of business and others forced into distress. In a developed economy, the necessary restructuring could be speedily effected. In an economy like China's with an underdeveloped financial system, the restructuring would be long drawn-out, painful, and could even damage the banking system significantly. If there is one lesson we have learnt in recent years, it is that emerging markets do not handle large exchange rate movements well. Moreover, it is not even clear that such a large exchange rate appreciation would have much of an effect on the U.S. current account deficit—quite possibly other countries in Emerging Asia would simply take up China's export share.
Instead, we would advocate a less interventionist approach where the authorities let the exchange rate react more flexibly to market forces—the authorities already have a framework for this, and they should use it. A more flexible exchange rate, especially if accompanied by more flexibility in emerging Asia, will allow the underlying forces adjusting international demand more room to play. Equally important, however, for China, is the process of modernizing the financial system so that both banks and corporations face a realistic cost of capital, invest sensibly, and offer a realistic return to savers. Not only can this reduce excessive investment in the Chinese economy, it can also reduce excessive corporate savings. Also, better retail credit can reduce the need for individuals to save to buy big ticket items like houses and cars, and higher investment returns can reduce the amounts individuals need to save for retirement. Both would help reduce savings and boost consumption. A growing China that consumes more will benefit not only itself but also the world.
Finally, let me attempt to gauge the effects of various policies on the unwinding of the current account imbalances using the Fund's Global Economic Model.
We first examine a benign unwinding with no change in policies—where private sector is forced, in a sense, do all the work. [See Chart 13] In particular, the U.S. fiscal deficit is assumed to remain around 4 percent of GDP (larger that it is at the moment). In this case, the adjustment scenario is characterized by a sizable—if relatively gradual—private sector-led adjustment, accompanied by lower U.S. and global growth, and noticeable but orderly real exchange rate adjustment in a number of regions. In the United States, a 15 percent real dollar depreciation is implied in the scenario. If nominal exchange rates aren't permitted to adjust in some parts of the world, then the adjustment in the real exchange rates occurs through higher inflation. For emerging Asia, the scenario implies a real exchange rate appreciation of about 15 percent; for the euro area and Japan an appreciation of about 5 percent. The outcome relies critically on the willingness of foreigners to hold U.S. assets in the face of further foreign exchange losses without demanding a higher risk premium.
In second case, we examine a disruptive adjustment. Asia is assumed to abandon its peg and protectionist measures are adopted in all countries. [See Chart 14] There is a sharp contraction in U.S. economic activity (as signified by the dotted line), a large depreciation of the dollar and a sharp correction in the U.S. trade balance. Elsewhere, the sharp appreciations entail deteriorating trade and current account balances, a slowdown of economic activity, and tighter monetary conditions to help contain inflationary pressures. The scenario does not explicitly consider any resulting financial market disruptions that would further hurt growth. The bottom line is that while one possible scenario is of a smooth adjustment, it requires the continued patience of international investors. If those investors prove unwilling, and if countries disrupt the trading process through protectionist measures, there is a risk of a substantial growth slowdown. This is the risk we want to minimize.
What will happen if the policy advice we have been proposing is implemented? First, we examine greater exchange rate flexibility in emerging Asia, accompanied by a decline in the accumulation of their net foreign assets. [See Chart 15] There is a temporary slowdown in GDP growth in emerging Asia, because of a weaker contribution of net exports, but consumption growth accelerates. Overall, the move toward more flexible exchange rates entails both nominal and real exchange rate appreciations, greater domestic demand and more muted inflationary pressure relative to the baseline. There is greater growth in both the United States and euro area-Japan region. Thus, increased exchange rate flexibility allows emerging Asia to cope with rapid external adjustment needs without jeopardizing macroeconomic stability.
What if in addition there is a substantial reduction in the U.S. budget deficit in the medium term, leading to a balanced budget by 2010? [See Chart 16] The tightening of fiscal policy leads to a notable improvement in the current account—by about 2 percent over ten years. At first U.S. growth suffers, but over time there is a reduction in long-term interest rates, boosting private investment (identified earlier as lagging) and raising long-run output. For the other countries, the outcome is similar—output is above the baseline in the long run and all regions experience a deterioration in their current accounts to balance the improvement in the United States along with a modest appreciations of their currencies.
Structural reform in the euro area and Japan, our last scenario, is modeled as an increase in product and labor market competition. It also has positive outcomes. [See Chart 17] When added to the above two policies, there is significant investment-driven increase in GDP growth in Europe and Japan. There is general improvement in current account balances and some appreciation of real exchange rates elsewhere over the medium-term.
While each individual policy action helps, benefits are magnified and risks of a disruptive adjustment minimized when they are taken together. [See Chart 18] Thus U.S. current account narrows faster, requiring less financing, and substantially lowering the risk of an abrupt adjustment—a clear instance in which a cooperative set of policies would be in the collective interest.
Let me conclude. The world economy has been resilient in the face of shocks, in part due to improvements in the quality of policy. This has allowed a variety of imbalances to build up. While the imbalances have been financed easily thus far, one concern we have is that if financing dries up, it will do so at the worst possible time for the world economy—when its strongest engine falters.
A second concern has to do with protectionism. It is all too easy for politicians to blame other countries for imbalances—after all, foreigners do not vote. The solution then appears easy. Impose punitive tariffs! Yet as we have seen, the imbalances are a shared responsibility, and no one country will be able to solve it unilaterally, least of all by imposing tariffs. And a tariff here will bring forth a tariff there, potentially harming the entire world economy. We have seen the movie before in the depression of the 1930s and it is frightening. It is to forestall such a descent into autarky that the Fund has been arguing that countries should avoid pointing fingers at each other. If instead countries see the imbalances as a shared responsibility, it will help guide the domestic debate in each country away from the protectionism that may otherwise come naturally. We should recognize that the need of the hour is sensible domestic policy reform. In addition, of course, we should continue with the process of reducing trade barriers, which means working towards an ambitious Doha round. Let me end my remarks here. Thank you.
1 The views expressed in this paper are those of the author and should not be attributed to the International Monetary Fund, its Executive Board, or its management.