Friday, June 12, 2009

Global imbalances and role of China

Martin Wolf points to a recent Goldman paper on the impact of China’s rise on the world economy that outlines four salient characterisitcs of the world economy in the last decade - huge increase in global current account imbalances (with, in particular, the emergence of huge surpluses in China led emerging economies); a global decline in nominal and real yields on all forms of debt; an increase in global returns on physical capital (due to newer technology, newer markets, increased labour supply etc); and an increase in the "equity risk premium" – the gap between the earnings yield on equities and the real yield on bonds. To this list, Wolf adds the strong downward pressure on the dollar prices of many manufactured goods.



The Goldman report claims that the low bond yields caused by newly emerging savings gluts drove the crazy lending whose results we now see. Someone had to borrow this glut and the US Government (and private financial market players) emerged as a willing borrower. While "global savings glut" hypothesis helps explain the first two facts, a massive increase in the effective global labour supply and the extreme risk aversion of the emerging world’s new creditors (the bursting of the stock market bubble in 2000 increased the perceived riskiness of equities and so increased the attractions of the supposedly safe bonds) explains the third and fourth features. The interventions in the foreign exchange markets by many large exporters to keep their currencies undervalued kept the prices of manufactures down.

On the way out of this structurally imbalanced macroeconomic condition of the world economy, Wolf writes,

"Today, Germany wants to preserve the value of its money, while China is desperate to preserve the value of its external assets. These are understandable aims. Yet, if this is to happen, debtor countries have to stabilise their economies without another round of profligate private borrowing or an indefinite rise in government debt. Both paths will ultimately lead to defaults, inflation, or both and so to losses for creditors. The only alternative is for debtors to earn their way out. At the level of an entire country that means a big rise in net exports. But if indebted countries are to achieve this aim, in a vigorous world economy, the surplus countries must expand demand strongly, relative to supply."


Update 1
Daniel Gros explains the way current account deficits are financed and how flow imbalances accumulated into large stock disequilibria. He also explains the securitisation leading to the crisis as the product of a maturity mismatch between foreign savers seeking short-term assets and excess supply of long-term US mortgage debt.

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