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Reducing the Risk from Global Imbalances, Remarks by John Lipsky, First Deputy Managing Director, International Monetary Fund, at the Ambrosetti 18th Annual Forum The Outlook for Financial Markets, Cernobbio, Italy
April 2, 2007
April 2, 2007
As Prepared for Delivery
It's a pleasure to be part of this panel discussion on identifying and addressing global risks.
I'll begin with a few words on the remarkable performance of the global economy in recent years and on the near-term outlook. The focus of my talk is on mitigating one source of risk to the global outlook, namely, that of high current account balances. How can these be reduced to safer levels while sustaining strong global growth?
Let's begin with recent global performance and the near-term outlook. I think it's useful, before we worry about what might go wrong, to reflect on what has gone right.
• We've just experienced the fastest four-year period of increase in global incomes in 30 years. This income growth has been shared by countries across the world. The world's two most populous countries are also among the fastest growing—and this has rescued millions from abject poverty. Sub-Saharan Africa has had growth in excess of 5% in recent years. Global growth has been anchored by strong productivity growth in many countries.
• Core inflation rates around the world remain at 40-year lows.
• Financial markets in emerging economies are growing in size and becoming more integrated with the global economy. The stock of domestically-issued bonds in emerging market countries tops US$3.9 trillion, constituting an important global asset class. And many emerging economies have been able to borrow in their own currency, suggesting that they have managed to atone, in foreign investors' eyes, for what been characterized as their "original sin."
What makes the performance of the global economy over the last five years even more impressive is that it has come in the face of adversity. Terrorist attacks have claimed lives and disrupted economic activity in many countries over this period. High and volatile oil prices have also posed a challenge.
Looking ahead, there are clearly many risks to the global outlook that bear close watching. Spillovers from ongoing corrections in the U.S. housing market and in financial markets are of course the most prominent of these risks. But the IMF expects that, while risks to the outlook remain tilted to the downside, global growth in 2007 will again be strong—close to 5 percent.
Few forecasters at the start of 2002—when the world economy was still against the ropes—would have predicted that five good years of global growth were likely to follow.
Of course, these five years have also seen an increase in the U.S. current account deficit and in counterpart surpluses in other parts of the world. I think to assess properly the risk from this development one needs a view of how these deficits and surpluses came into existence.
To me, the story begins around 1990 when the collapse of communism ushered in the possibility of a truly global economy. But unlike the Bretton Woods vision of fixed exchange rates and closed capital markets, this was a world of floating exchange rates, at least among the major industrialized nations, and relatively open capital markets.
It was not long before this new world went through a severe testing period, starting with the Mexican crisis in 1994 and then, from 1997 onwards, the Asian crisis, the Russian default, LTCM, Brazil, Argentina—and so on.
These crashes were not pretty but the situation would have been uglier still had policymakers, particularly in the industrialized countries, repeated the mistake of the Great Depression and stepped on the brake instead of the accelerator.
Happily, they did not repeat their mistake. Instead, starting in 2000-2001, following this series of very serious shocks to the global economy, there was a move towards monetary accommodation in countries that had room to do so. This was accompanied, in the United States and in some other countries, by fiscal accommodation as well.
This accommodation produced results far more favorable than were anticipated by either policymakers or financial markets. The policy-boosted demand growth in the United States was critical to supporting the global upturn that started during 2002. At the same time, globalization permitted emerging market countries to benefit directly through export gains. This is why the post-2002 expansion has been shared universally to an unprecedented degree.
Many emerging market countries took advantage of the favorable environment to strengthen their budgetary positions and accumulate international reserves, enhancing their prospects for continued good performance. Of course, financial markets have reflected this unexpected economic success.
Those to me are the cyclical roots of the present pattern of current account balances. Structural factors have contributed as well. Globalization of capital flows has led to the growth and deepening in financial markets. These dynamics, when seen as changes in the investor base or the `supply side' of capital flows, reveal some key structural changes. Let me mention three:
• First, in industrialized countries, assets under management of institutional investors—pension funds, insurance companies and mutual funds—have surged, rising from $21 trillion in 1995 to $53 trillion in 2005.
• Second, the home bias of the investor base has declined markedly. The globalization of asset allocation has gained traction with declines in informational and other barriers and advances in financial innovation that allow unbundling and reallocation of risk.
• Third, emerging market central banks and sovereign wealth funds have become key global players in cross-border asset allocation.
These structural changes make the assessment of the 'sustainable' level of current account deficits difficult. Rapid financial globalization enables countries to finance larger current account deficits for longer periods of time than may have been possible, say even a decade ago. Old rules of thumb about what's good and what's bad, what's sustainable and not sustainable, have come under great question.
This is not to suggest that lowering current account balances to safer levels is not desirable. As the global economy has stabilized, there has been a withdrawal of much of the cyclical stimulus that was put in place in 2000-2001. This is appropriate and, over time, it is bringing about the changes that are needed to reverse the U.S. current account deficit.
The big change to watch for is a turning point in the U.S. savings rate. The decline in the U.S. household savings rate over the past several years reflects the astonishing growth in household net worth—not just from home ownership but from ownership of financial assets. Inflation fell unexpectedly and with it came a decline in real long-term interest rates that raised the value of long-lived assets. At the same time, an surge of productivity meant that incomes had a potential to grow at 3 ½ to 4 percent a year rather than 2 percent a year.
Savings in the United States should return to more normal levels as these forces abate. There is only so much room for further declines in inflation and interest rates. Nor is productivity growth likely to remain elevated—wonderful though that would be. With household net worth rising less rapidly, the U.S. savings rate should rise, bringing about the decline in domestic demand needed to change the course of the current account deficit. The process will be helped along by reductions in U.S. fiscal deficits over the medium term.
Of course, in the surplus countries, the opposite needs to happen—there we need a strengthening of domestic demand. There has been some progress on structural policies in the euro area and Japan that will help in this regard. In the euro area, a revised EU Directive was adopted to help strengthen competition and productivity in the services sector. In Japan, measures to enhance competition and encourage labor force participation were recently adopted.
Consumption in China will also strengthen as the financial system continues to develop and precautionary savings are reduced. Exchange rate changes will help: the pace of renminbi appreciation against the U.S. dollar has increased over the past year and the currency has appreciated modestly in real effective terms since the implementation of reforms in July 2005. We also expect domestic spending by oil exporters will continue to rise as investment plans, particularly in the energy sector, are firmed up.
In short, it is likely that global imbalances will unwind gradually, through a further rebalancing of domestic demand across countries, with supportive market-driven movements in real exchange rates.
At the IMF, we've been helping this process along not only through our bilateral discussions with countries but through a new process of multilateral consultations. These first of these consultations have brought together participants from China, the Euro area, Japan, Saudi Arabia and the United States. The discussion has resulted in a better understanding of the policy agenda of each participant. And we hope that this will be reflected in policy choices that are in each country's interests but also contribute to the reduction of global imbalances.
Thank you.
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