Speech by Rodrigo de Rato, Managing Director of the International Monetary Fund, the Harvard Business School Alumni DinnerWashington DC, February 26, 2007
As Prepared for Delivery
1. Thank you very much. It is a pleasure to be with you. I'd like to say a few words tonight about the state of the world economy, and in particular about some risks that I think are not sufficiently appreciated by citizens and may also be underestimated by financial markets.
2. The institution that I head, the International Monetary Fund, has many responsibilities. I am sure that most of you are familiar with our lending to countries that are experiencing economic crises. We also work extensively and in partnership with the World Bank with low-income countries to help them make progress toward achieving the Millennium Development Goals. Tomorrow, an important report will be issued on the way in which the Fund and the World Bank collaborate with each other. And at the heart of the Fund's responsibilities is monitoring the economies of all of our members—not only emerging markets and developing countries, but also industrial countries—and also monitoring the global economy. Tonight I would like to share with you some information and analysis that comes from this work.
3. At the moment, the world economy is in a strong position. We have already seen several years of strong growth, and we expect that global growth will once again be close to 5 percent in 2007. This would be the fifth year of strong growth—indeed the strongest five-year span for the global economy since the late 1960s. In the United States, the speed of the expansion has eased—largely reflecting the slowdown in the housing market, which subtracted over 1 percentage point over growth in 2006. But in the euro area and Japan, growth momentum looks solid. China and India continue to be engines of growth, and many other emerging market and developing countries are enjoying a continuation of the strong growth of recent years.
4. The financial markets are basking in the glow of this sunny outlook. Equity markets are setting new highs while bond markets have shrugged off increases in interest rates set by central banks. Spreads on corporate and emerging market sovereign debt are at historic lows. Liquidity is plentiful.
5. The risks to economic prospects also seem to have diminished. Six months ago, we were worried about fallout from a downturn in the U.S. housing market, but so far it seems to be limited, apart from credit strains in those parts of the mortgage market that engaged in particularly creative lending. We were worried about high and volatile oil prices, but for the moment they have fallen. And we were worried about inflation pressures as the economic cycle matures. That risk has not gone away, but so far we have not seen sharp increases in inflation either. Oil price moderation has helped.
6. But one risk that is still very much with us is that of a disorderly adjustment of global payments imbalances. The risks of this are relatively low, but the costs are high. And although there have been some signs that global imbalances may be stabilizing, imbalances are likely to remain large for the foreseeable future. These imbalances are reflected in a deficit in the current account of the balance of payments of the United States that remains stubbornly large. The United States depended on foreign savings to the extent of about 6½ percent of its GDP in 2006, and the deficit is expected to be at a similar level this year. The counterpart to this deficit is large surpluses in the external accounts of major Asian emerging market countries, notably China, oil-exporting countries, and in Japan. The imbalances between the United States and the rest of the world are not sustainable over the long term. The risk is that if nothing is done to reduce them gradually, they will instead be reduced suddenly, and in a disruptive way. For example, if investors become suddenly unwilling to hold U.S. financial assets at prevailing exchange rates and interest rates, this could lead to an abrupt change and could cause global financial market disruptions, as well as an economic downturn.
7. The Fund has taken the lead in bringing a number of key countries together to share analysis of the nature and consequences of global imbalances and to help build a common understanding on policies designed to reduce these imbalances while supporting global growth. Reducing global imbalances will be a gradual process—indeed one of the purposes is to avoid an abrupt change. But all of the participants have indicated that they find the Fund's initiative useful.
8. Over the past year, market and policy developments have gone in the right direction to reduce imbalances. The U.S. federal deficit—one of the factors behind the current account deficit—has fallen, though this is at least in part due to revenue gains that may be temporary. There has been some progress on greater exchange rate flexibility in China and on structural reforms in the euro area and Japan. Saudi Arabia and other oil exporters are following through on their plans to increase investment. These measures should help to achieve a rebalancing of global demand that would support an orderly unwinding of the large U.S. current account deficit without undermining global growth. They are important and welcome developments.
9. But there have been other developments which are less welcome, and which can be seen as the ripple effects of the continuing global imbalances. The first is the emergence of strains in global currency markets, especially affecting the euro and the yen. This could trigger a sudden shock to financial markets. The second is the stirring of protectionist sentiment around the world. This could result in a slow strangulation of global growth.
10. In the currency markets, there has been some depreciation of the dollar in real effective terms over the last year, and this will help to reduce the U.S. current account deficit. But almost all of this depreciation has been against the euro and pound sterling, rather than against the currencies of the major surplus countries. What would be better is for China to make more use of the flexibility it gave itself over a year ago to allow an appreciation of the renminbi against the dollar. This is needed in itself, as appreciation in effective terms would give the authorities room to use monetary policy to curb investment and growth. This is something that is on the macroeconomic policy agenda of the Chinese leadership. Furthermore, since other Asian countries are concerned about competitiveness with China, such a move could also encourage them to allow upward adjustments in their own exchange rates.
11. Another development that gives rise to concern is the growth of the yen carry trade. As you know, this is the practice of borrowing in yen to purchase securities in other countries. The attraction is that Japanese interest rates are low. For example, investors can borrow in Japanese yen, and lend in New Zealand dollars at an interest rate spread of about 700 basis points. The effects of the carry trade can be seen in capital flows into countries like Brazil and Turkey, and in the growth of yen-dominated mortgages in countries ranging from Korea to Latvia. Partly owing to carry trades, and also because of increased international investment by Japanese residents, capital flows out of Japan have risen. As a result, despite a large current account surplus, there has been downward pressure on the yen in the short run. Indeed, in real effective terms, the yen is now at a 20-year now.
12. The carry trade is not a consequence of global imbalances. Rather, it reflects the globalization of financial markets and the current environment of low volatility and wide interest rate differentials. But it could lead to more entrenched exchange rate misalignments that worsen global imbalances. The depreciating yen led to an increase in the current account surplus of Japan to almost 4 percent of GDP in 2006. Moreover, both financial markets and countries are exposed to risks if there is a sudden reversal of financial flows. For example, a disruptive unwinding of carry trade positions occurred in October 1998, when the U.S. dollar fell by 15 percent against the Japanese yen in four days. Compared to 1998, there are now a greater number of currencies involved in the carry trade and more diversification in the investor base. The latter lessens the risk of an abrupt unwinding of carry trade positions. Nevertheless, I am concerned that investors and the countries into which funds are flowing are not sufficiently attentive to the risks.
13. There is no simple solution to this problem. The Bank of Japan increased interest rates by a quarter of one percent last week. However, with the economy only just having emerged from years of deflation and inflation still uncomfortably close to zero, it needs to be cautious in increasing rates. Moreover, the decline in home bias and demographic trends in Japan suggests that both institutional and retail flows out of Japan may persist. Therefore, substantial interest rate differentials are likely to remain. Investors will make their own decisions as to what is a safe investment, and at the moment they appear to be relatively complacent about the risks.
14. However, there are some actions that can usefully be taken. There are great uncertainties about the overall size of the carry trade and the location of risks. It would be useful for government regulators and central banks to do all they can to get better information on this, so that they can adequately assess any systemic risks. And those countries into which funds are flowing should look carefully at their own macroeconomic and prudential frameworks, and be prepared for a reversal of flows at some point in the future.
15. If financial markets seem complacent about currencies at the moment, then some political leaders and many citizens seem overly complacent about the risks of protectionism. Protectionist sentiment has many manifestations, from the doctrine of national champions in Europe, to legislative proposals that aim to protect some industries through tariffs or other protectionist measures in the United States and elsewhere. We in this room are very aware of the benefits of free trade. We know that the prosperity of the past 60 years has been founded on increased trade. But we are also aware that many people doubt the benefits of trade. This is not just a matter of perceptions. There are some real losers from the continued "migration" of manufacturing jobs from advanced economies to emerging markets and the increased outsourcing of services jobs. And there are real challenges that have to be addressed.
16. One priority is to be clearer about the benefits of trade. While these benefits can be difficult to quantify, studies indicate that trade liberalization, including trade deals under the GATT and the WTO have lifted annual U.S. incomes by as much as 750 billion U.S. dollars. Indirect gains arising from investment and similar reforms have been of a similar magnitude. Moreover, U.S. firms engaged in trade tend to be more productive, have higher employment growth, and pay higher wages than domestically oriented firms.
17. Another priority is to be responsive to the costs of changing trade patterns for those who must adjust. Concerns about worker displacement, higher economic uncertainty, and increasing inequality are legitimate. But they should be addressed by policies that strengthen the economy's adaptability, rather than weaken it. For example, trade adjustment assistance can both protect workers and facilitate their movement to growing industries. More generally, more could be done to support education and retraining and to facilitate labor mobility. For example, increasing the portability of healthcare in the United States would be a useful step forward.
18. But let me conclude by stressing that the most immediate priority is to bring the Doha Round to a conclusion that delivers ambitious reforms. It will take many hands to complete this work, but the United States has a particularly important role to play. Given the delays of the past year, completing the Doha Round will almost certainly require that Congress grant an extension of the U.S. administration's fast track negotiating authority. I hope they will do so. While the terms of such an extension are a matter for the U.S. Congress, the results of their decision are important not only for the United States but also for the rest of the world. I believe we are at a crucial point in this debate. And I hope that business and academia, as well as the governments concerned, will do their part in making the case for free trade.
19. Thank you very much.