Investment Restraint, The Liquidity Glut, and Global Imbalances: Remarks by Raghuram G. Rajan, Economic Counselor and Director of Research
IMF News, November 16, 2006
Source details
- Canonical URL
- Investment Restraint, The Liquidity Glut, and Global Imbalances: Remarks by Raghuram G. Rajan, Economic Counselor and Director of Research
Other formats
Bibliographic details
- Published: November 16, 2006
Overview
- Speech delivered at the Conference on Global Imbalances organized by the Bank of Indonesia in Bali, November 16th 2006.
- Argues three global ingredients explain low long-term real interest rates and large global imbalances:
- A widespread surge in productivity.
- A high desired savings rate, particularly supported by corporations and emerging market governments.
- Global investment in physical assets that has not returned to past levels (termed "investment restraint").
The Productivity Revolution
- Key observations:
- Fourth year of strong world growth (context: speech dated November 16th 2006).
- Productivity growth fostered by information technology and global supply chains.
- Rapid worldwide productivity growth explains: strong commodity demand; ability of emerging markets to withstand commodity price increases; contained inflation despite rising raw material costs; buoyant household incomes and corporate profits.
- Emphasizes that productivity surges occurred not only in the U.S. (since 1995) but also in emerging markets.
The Rise in Desired Savings
- Findings on savings behavior:
- Household savings in many industrial countries have drifted lower, with exceptions like Germany.
- Industrial country corporations have increased excess savings (undistributed profit less capital investment) — see WEO September 2005.
- Drivers of corporate excess savings:
- Productivity growth not paid out to labor, raising corporate profits.
- Lower corporate taxes and decreasing dividend payments.
- Corporations maintaining large cash hoards amid increased firm-level volatility.
- Emerging markets:
- Governments running primary fiscal surpluses in some cases (supported by commodity export gains).
- Households increasing savings due to uncertainty and limited retail credit (example explicitly: China).
- Emerging market corporations, especially in natural resources, building excess savings.
- Conclusion: continuing high desired savings among households, corporations, and governments—especially in emerging markets—is the second key ingredient.
The Fall in Realized Investment
- Central puzzle: despite high productivity and savings, physical investment remains subdued.
- Explanations considered:
- Working off past excessive investment (e.g., telecoms overinvestment in late 1990s).
- Shift from hard physical assets to intangible investments (training, R&D) that are expensed and not easily tracked; but corporate profitability remains high.
- Capital goods prices falling (e.g., computers) — counterarguments:
- High depreciation rates of rapidly cheaper capital goods.
- If cheaper, firms should buy more, not less.
- Economic and political uncertainty deterring investment, especially in emerging markets.
- Offshoring: industrial-country firms investing more overseas (FDI in emerging markets near an all time high) rather than domestically; uncertainty about long-term predictability of non-industrial country environments may limit long-term, hard-to-move investments.
- Conjecture: global investment restraint and limited greenfield FDI from rich countries to emerging markets may reflect political and economic uncertainty.
The Global Liquidity Glut
- Mechanism:
- Low flow of new collateralizable hard assets constrains debt issuance.
- If investment shifts to non-securitizable assets (e.g., firm-specific human capital), it reduces collateral available for finance.
- Result: mismatch between high desired savings and low realized investment creates a liquidity glut, pushing long-term real interest rates lower globally.
- Market implications:
- Excess liquidity spills into existing real and financial assets (real estate, high-risk credit, private equity, art, commodities), raising prices.
- Illiquid markets have been pushed up most by small infusions of liquidity.
- Emerging market debt becoming mainstream partly because of shortage of new investible assets rather than solely improved creditworthiness.
- Easy refinancing can create self-fulfilling reductions in defaults and perceived credit risk.
- Role of monetary policy and foreign official flows:
- Rajan argues G-3 accommodative policy is not the primary driver of low long rates; policy rate changes had limited effect on long rates.
- Foreign central bank purchases of U.S. assets reflect domestic savings-investment imbalances and are not necessarily the direct cause of low U.S. long rates (see Warnock and Warnock (2006)).
The Liquidity Glut and Global Imbalances
- How differences in domestic financial structures shape current accounts:
- United States: surge in productivity translated into late-1990s investment boom; since 2002 expansion more consumption- and real estate-focused, enabled by deep, arm's-length financial markets allowing borrowing against future incomes. Result: large current account deficit (also see WEO September 2006).
- Emerging markets: cautious investment after past booms and busts; limited housing and retail finance constrain household consumption; results in net savings/current account surpluses. Exception: India moved from surplus to increasing deficit due to a more vibrant financial sector.
- U.S. financial innovation and securitization drew global savings into the United States, helping support the dollar amid a worldwide shortage of investible assets.
How Will All This End? (Scenarios and adjustment channels)
- Long-run tendencies:
- Low real interest rates may be more representative historically than the high rates of the previous three decades (see Catao and Mackenzie (2005)).
- Demographics (aging populations in developed countries) imply rebalancing must occur primarily in non-industrial countries.
- Channels for adjustment:
- Increased foreign direct investment into emerging markets.
- Development of financial systems in emerging markets to intermediate savings into productive investment.
- Rising consumption as safety nets improve and retail finance expands, reducing desired savings.
- Demographically-driven changes forcing reversal of the perverse pattern of net capital flows from poor to rich.
- Risks and dangers:
- Financial innovation creating too many assets of one class leading to gluts and abrupt corrections (example: US housing market correction risk).
- Agency problems in financial systems amplified by cheap and easy finance.
- Small changes in excess liquidity can cause large swings in prices of illiquid assets and valuations.
- Policy implications:
- Ensure government policy does not impede adjustment; IMF efforts aimed at this objective.
- Continued caution is warranted because adjustments rarely proceed smoothly.
Conclusions and Policy Recommendations
- Summary conclusions:
- Fundamental forces—productivity surge, high desired savings, and investment restraint—explain both global imbalances and the global liquidity glut.
- Hope for gradual correction: long-term interest rates moving up slowly, exchange rates adjusting, and global imbalances narrowing without major blow-ups.
- Policy recommendations and cautions:
- Facilitate the development of emerging market financial systems to channel savings into investment.
- Improve safety nets and retail finance in emerging markets to reduce precautionary household savings.
- Monitor and manage financial innovation to reduce the risk of asset-class overshooting and agency problems.
- Avoid government policies that impede necessary real and financial adjustments.
- Maintain vigilance given the potential for abrupt corrections in illiquid asset markets.
Remarks by Raghuram G. Rajan, Economic Counselor and Director of Research, IMF. November 16, 2006.