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Perspectives on the Global Economic Landscape and the Role of the Dollar, Address by John Lipsky, First Deputy Managing Director, IMF
July 22, 2008
As Prepared for Delivery
The global economic and financial landscape is rapidly evolving. Just a year ago, the global economy was in the fifth year of an exceptionally broad-based expansion, led by strong growth in emerging economies and accompanied by low inflation, well-anchored expectations and low interest rates.
Today, the situation is far more difficult, featuring multiple and novel challenges. Energy and commodity prices have soared, exacerbating global imbalances while pushing inflation higher and potentially undermining inflation expectations. Asset prices are falling in many key markets, stunting household net worth while spurring financial market turmoil and raising doubts about recent market innovations. Everywhere, confidence about near-term prospects is weakening.
Together, these factors have created difficult-and differing―tasks for policymakers. In advanced economies―where growth is projected to fall below potential in 2008 and 2009- supporting growth while stabilizing the financial system comprise key objectives. At the same time, the spectacular energy and commodity price rises have led to a notable relative price shift of unusually uncertain scope and duration. In this context, policymakers' task is to accommodate durable relative price changes, while minimizing the resulting overall economic and financial disruption, and preventing any deterioration in long-term inflation expectations.1 In many key emerging economies, combating rising inflation-resulting from both strong domestic demand growth and surging commodity prices-is the central challenge. Finally, achieving better balance in demand growth across countries is needed in order to boost confidence by reducing global payments imbalances.Overarching global tasks include drawing the appropriate lessons for financial market regulation from the current turmoil, strengthening the international trade system, and protecting the most vulnerable from the potentially dangerous impact of sharp price increases for food and fuel.
Under the current circumstances, it is not surprising that many scholars and financial market analysts have been re-examining past episodes of economic and financial stress involving slowing demand and rising inflation in search of precedents and insights. While some valuable lessons no doubt will be uncovered, the seminal shifts that have taken place in globalization and financial market structure also could make historical analogies misleading. For example, questions have been raised about the role that should be anticipated for exchange rate shifts in the international adjustment process. As I will emphasize in my remarks today, exchange rate considerations are likely to be central to confronting today's challenges, but their short-term behavior should not necessarily be expected to closely mimic past experience, when market and economic configurations differed in many important ways.
One thing is clear, however. Achieving success in the differing tasks I have described is a shared global responsibility. This simple but powerful conclusion was underscored last year by the participants in the Fund's pathbreaking Multilateral Consultation on Global Imbalances. I will return to the issue of shared responsibility later in my remarks, but first I will outline the IMF's views on the global economic and financial outlook and then I will provide some perspectives on whether the dollar's recent depreciation has contributed constructively to a resolution of the multiple challenges facing the global economy, or added to the problems.
Global Outlook
In our latest World Economic Outlook forecast update, we project global growth to slow to around 4 percent in 2008 and 2009, compared with 5 percent in 2007. Activity is expected to moderate this year across both advanced and emerging economies, before recovering gradually in 2009. Despite this global slowing, growth is still expected remain at or above trend in emerging economies-at around 7 percent in 2008 and 2009-while advanced economy growth will be below potential for the first time since early in this decade.
At the same time, rising energy and commodity prices have boosted inflation pressures, particularly in emerging economies. In advanced economies, headline inflation rose to 3½ percent in May 2008 over a year earlier, while core inflation remained at 1¾ percent. The increase in inflation is more marked in emerging economies, where headline and core inflation have risen to 8½ percent and 4¼ percent, respectively—the highest rates since the late 1990s. However, deterioration in inflation expectations is a potentially serious risk globally.
Of course, monetary policy must aim, first and foremost, to head off inflationary pressure, while also being mindful of downside risks to growth. In advanced economies, the risk of second-round effects from the surge in commodities prices and continued stress in financial markets is complicating the response to the slowdown. That said, inflationary pressures must be monitored closely, as allowing the past decades' gains in lowering inflation and inflation expectations to be lost would seriously undermine future economic progress.
In emerging economies, many central banks have raised policy interest rates in response to rising inflation, but interest rates generally remain negative in real terms, particularly in countries where exchange rate management has limited monetary policy flexibility. There is a risk that many of these countries have "fallen behind the curve" in tightening policies. In several countries, particularly those whose growth above trend, monetary policy needs to be tightened further. Greater fiscal restraint and, in some cases, more flexible exchange rate management also may be needed.
Financial market conditions also remain difficult. Forceful policy responses to the financial turbulence and encouraging progress toward bank recapitalization have represented important contributions. Nonetheless, indicators suggest that credit deterioration is widening and deepening as economic conditions weaken. And as advanced economy banks—especially in North America and Europe—deleverage and rebuild capital, lending is beginning to be squeezed, further pressuring households and clouding the outlook for the real economy and the financial system. Moreover, increased inflation risks have raised economic uncertainty and reduced the flexibility for monetary policymakers to ease financial stress. As we have emphasized previously, advanced economy policymakers may need to deploy decisive and innovative measures in order to safeguard financial stability and over time to put the global financial system on a firmer footing. This could include committing the public balance sheet-a policy course we have labeled previously the "third line of defense".2
Appropriate structural policies in advanced, emerging, and developing economies alike also have a role to play in restoring demand-supply balances in energy markets.3 On the demand side, increasing the pass through of international oil prices to domestic prices to allow a demand response to the reality of higher international prices is critical, particularly in emerging economies. In advanced economies, improving conservation and energy efficiency will be important to help to moderate the growth in energy demand. On the supply side, oil producing countries should adopt policies to foster investment in the oil sector and in energy resources more generally.
Putting the Recent Dollar Decline in Perspective
Turning to the U.S. dollar, I will try to put the recent decline in perspective.
As many of you know, the Fund has intensified its efforts to address exchange rate issues. Last year, the Fund's Executive Board revised our framework for exchange rate surveillance, and we have been further developing our tools for analyzing exchange rate levels on a broad, medium-term basis. 4 In this context, understanding the implications of the dollar depreciation over the last few years is a central challenge.
The U.S. dollar has depreciated by about 25 percent in real effective terms since early 2002, in what has been one of the largest sustained episodes of dollar depreciation in the post-Bretton Woods era. The largest previous such episode-where the dollar depreciated by over 30 percent in real effective terms-took place between 1985 and 1991, also against the background of a large U.S. current account deficit. In both episodes, the pace of depreciation was relatively gradual, with daily changes below 2-3 percent in nominal effective terms. In both cases, the US currency in broad terms moved in line with shifts in interest rate differentials. Moreover, in the earlier case, the dollar depreciation episode ended with the U.S. currency's level roughly consistent with broad, medium-term equilibrium, as per Fund calculations. Following the post-2002 decline, we assess that the U.S. currency today is the closest to its medium-term equilibrium value in a decade.
During the 1985-91 episode, the US current account deficit narrowed from a high of 3½ percent of GDP in 1987 to about balance in 1991. In contrast, the current episode has not been associated with a quick and sharp adjustment in U.S. current account balances. Indeed, in the recent episode, the current account widened initially to reach an all time high of nearly 7 percent of GDP in late-2005. It began to moderate only in 2006, and remained at around 5 percent of GDP in the first quarter of 2008. This modest shift has created doubts about the impact of exchange rate flexibility. However, when the change in the current account balance over the two episodes is deconstructed, accounting for some lags to adjust for the timing of the export and import responses to the depreciation, it becomes clear that two key factors are driving the difference in the behavior of the current account in the two episodes.
• The first is the oil trade balance. In the previous episode, the price of oil initially fell and then remained roughly flat in US dollar terms. This led to an very modest improvement in the oil trade balance of 0.1 percent of GDP between 1987 and 1991. By contrast, oil prices have risen rapidly over the past few years to a record high. Thus, between 2004 and 2008, the U.S. oil balance is expected to have deteriorated by 1.3 percent of GDP.
• The second key factor underpinning the difference in the current account behavior is the receipt of large transfers associated with the first Gulf War in 1991—amounting to as much as 0.7 percent of GDP. Similar transfers have not occurred in the current episode.
The implication is that, after stripping out the oil trade balance and war-related transfers, the change in the US current account between the two episodes in fact appears to have been roughly similar. The "underlying" current account (excluding oil and transfers) improved by 2.7 percent of GDP in the previous episode, compared with 2.4 percent in the current period. Moreover, in the earlier episode, the depreciation was more "front loaded", with the bulk of the depreciation occurring between 1985 and 1989. In the current episode, half of the depreciation has taken place since 2006. Given the long lags (up to 2 years) in the current account response to exchange rate changes, we expect to see further improvement in this "underlying" current account in the coming years.
The Dollar Decline and Global Imbalances
If the decline in the value of the dollar is supporting a narrowing of the actual and projected U.S. current account deficit, it is thereby helping to promote an inevitable shift in the sources of growth between tradable and non-tradable sectors in both surplus and deficit economies, and it will help to reduce global imbalances. At the same time, however, the currencies of many economies with flexible exchange rates have appreciated markedly. Indeed, in our view, the euro is now overvalued relative to medium-term fundamentals, while the currencies of many current account surplus countries, including China, remain substantially undervalued, despite a small appreciation in real effective terms. The lack of adjustment in the currencies of several economies with inflexible exchange rate regimes and large external surpluses has not been supportive of an adjustment in global imbalances. Moreover, to the extent that real appreciation in these currencies has taken place more recently, it is largely due to accelerating inflation - hardly an ideal outcome.
Because an orderly adjustment of global imbalances with sustained global growth would be more likely if countries recognized their shared responsibility for a successful outcome, the IMF in 2006 initiated the Multilateral Consultation on Global Imbalances. A key outcome of these Consultations was the presentation of a set of mutually consistent policy plans specified by the five participants-the United States, the euro area, Japan, China, and Saudi Arabia. Key components of these plans include a reduction in the current account deficit in the United States through a shift toward greater domestic saving and improved net export performance; structural reforms along with increased flexibility of the renminbi with respect to a basket of currencies in order to support a rebalancing of Chinese growth toward domestic consumption; an increase in infrastructure and social spending in Saudi Arabia to alleviate supply bottlenecks and reduce the current account surplus; further progress on growth-enhancing reforms in Europe; and continued structural reform , including fiscal consolidation, in Japan.
Most recently, the sharp rise in oil prices has outstripped near-term Saudi stabilization efforts. Moreover, fiscal consolidation in the United States is being delayed by the U.S. slowdown and the fiscal stimulus package to support the economy. And while China has made some progress in rebalancing its growth, exchange rate flexibility has taken place only incrementally. Thus, global imbalances are projected to remain high in the near term, while global growth slows.
What does this imply for policies? For our part, we at the IMF continue to view the policy plans put forth by participants of the Multilateral Consultation on Global Imbalances as relevant. At the same time, we recognize that they will need to be implemented flexibly as circumstances have changed, and we accept that large imbalances may be with us for longer than we had originally envisaged. In particular, high commodity and record energy prices will lead to very large surpluses in oil exporting countries. The implication is that, while the dollar depreciation is helping to reduce the U.S. current account deficit, it has not been sufficient to alleviate imbalances and risks. Rather, new misalignments may be emerging and risks may be shifting.
The Dollar as a Reserve Currency
The latest combination of developments has even given rise to speculation about potential evolution in the constellation of international reserve currencies. Notwithstanding the dramatic claims by some, there is no doubt that the dollar will retain the central role, even though it may gradually share the stage with other currencies to a greater degree than at present.
The past decade has been marked not only by the decline in the value of the dollar, but also by the successful introduction of the euro, and the rise of emerging economies. In the 1985-91 episode of dollar depreciation, there really was no viable alternative to the dollar as the sole reserve currency. The Japanese, German and U.K. economies were much smaller than that of the United States, and their financial markets were less well-developed and less liquid.
Today, the euro area economy is of a similar size to the United States (each accounts for roughly ¼ of world GDP, based on market exchange rates), its financial markets are deep and liquid (although not yet equivalent to that of the United States in this regard), and it accounts for a large share of world trade.5 6 Thus, while the dollar will not be replaced as the dominant international currency, it is quite likely that, eventually, the dollar will begin to share this role with the euro.
Other currencies are playing a secondary role in the international arena. For example, the renminbi eventually may grow in importance as international currency as the Chinese economy grows in size, but this would also require full currency convertibility, an opening of the capital account, significantly more developed financial markets, and a track record of low and stable inflation-all of which are prospective at this time.
For now, the dollar retains its dominant role in both international transactions and as a reserve currency, accounting for nearly two-thirds of central bank international reserve holdings in the first quarter of 2008.7 Emerging economies-a group of great interest because of their rapidly increasing reserve holdings-have an average dollar share of around 60 percent, and this share has remained roughly unchanged since 2004.In the longer run, the demand for dollar assets and dollar reserves will depend on global developments. For example, if oil prices remain high, current account surpluses of oil-exporting countries are likely to increase rapidly. If those countries seek to invest their surpluses through vehicles—such as Sovereign Wealth Funds—which typically hold more diversified portfolios than central banks, demand for dollar assets potentially could decline from this source. That said, our estimates-based on a model-based simulation-suggest that the effect of this type of portfolio shift on the dollar would be very modest.
More generally, the move toward floating exchange rate regimes worldwide suggests that broader diversification of reserves is to be expected over time, but that the dollar will continue to play the central role in international reserves for the foreseeable future.
Conclusion
The challenges that I have discussed today are eliciting policy responses at both a global and a country level. The multiple, and novel, challenges facing the global economy suggest that innovative solutions may be needed to address some aspects—particularly with respect to restoring confidence in the financial sector.
At the same time, it is essential that inflation remains under control. This implies that monetary and exchange rate policies should be aligned in order to insure that this goal is met. This task is complicated, however, by slowing global demand, and policymakers must be mindful of risks to growth as well as to inflation. However, more assertive policy tightening will needed in many emerging economies where underlying inflation is picking up, activity continues to expand rapidly, and supply constraints are binding. In advanced economies, timely adjustment will be required as economies recover.
With regard to exchange rates, the IMF's view is that the substantial dollar depreciation so far is helping to bring down the U.S. current account deficit, and has moved the dollar close to its medium-term equilibrium level. Looking forward, sustaining this outcome while reducing other currency misalignments would make a positive contribution to attaining the dual goals of sustaining global growth while reducing global imbalances.
As I have discussed already, appropriate macroeconomic and financial policies will be required to attain this goal. Not only policy actions are central to this task, however. For example, the impressive flexibility of the U.S. economy will help the adjustment process as will structural shifts in other economies. As the participants in the Multilateral Consultation agreed, insuring that the adjustment needed to preserve this decade's impressive progress are implemented successfully is a shared responsibility. The IMF plans to play an active and appropriate role in achieving new progress.
Thank you.
1 See "Commodity Prices and Global Inflation", speech by John Lipsky at the Council on Foreign Relations, New York City, May 8, 2008.
2 See "Dealing with the Financial Turmoil: Contingent Risks, Policy challenges, and the Role of the IMF", speech by Mr. John Lipsky, at the Peterson Institute, March 12, 2008.
3 See "The Role of Policies to Foster Oil Sector Investment in a Global Context", remarks by John Lipsky at the 11th Energy Forum/3rd International Energy Business Forum, Rome, Italy, April 20-22, 2008
4 See Lee, Jaewoo, Gian Maria Milesi-Ferretti, Jonathan Ostry, Alessandro Prati, and Luca Ricci, "Exchange Rate Assessments: CGER Methodologies", IMF Occasional Paper No. 261, April 7, 2008.
5 On a PPP basis, the euro area account for 16 percent of world GDP compared with a bit over 20 percent for the United States.
6 Euro area exports—including intra-regional exports—account for 30 percent of world exports, compared with 8 percent for the United States. Intra-regional exports account for 50 percent of euro area exports.
7 Based on data from the Currency Composition of Official Foreign Exchange Reserves (COFER), an IMF database that keeps end-of-period quarterly data on the currency composition of official foreign exchange reserves. These data—from 138 countries—cover about ⅔ of global international reserves and nearly all of advanced economy reserves, but only ½ of emerging economy reserves.
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