Friday, September 24, 2010

The global macroeconomic rebalancing challenge

The events of the last three years have ignited intense debate about the prospects for the world economy and the policy measures that need to be taken globally and across individual economies to improve them. Global macroeconomic re-balancing has been a constant theme in all these debates. I have blogged about them here, here, here, here, here, here, and here.

The fundamental global imbalance is that the emerging economies are saving too much (and consequently spending too little), while the developed economies are spending beyond their means (and by corollary saving too little). Apart from manifesting in their current account surpluses/deficits and foreign exchange surpluses, these imbalances have important secondary influences on the development of manufacturing sectors and financial markets across the developing economies.

Further, as Stephen Roach recently pointed out, until developing Asia is able to shift its reliance from exports and external demand to private consumption and internal demand, Asia may not be in a position to take the baton of global leadership from the developed world. Nor will China be able to chart a growth trajectory that is decoupled from the fortunes of the developed economies, especially the US. In fact, currently, the US and China appear locked into a "mutually assured economic destruction" battle.

The East Asian currency crises of 1997-98 and its bitter lessons have had a profound impact on policy-makers across much of the emerging economies, especially those in Asia. And the Great Recession of 2008-09 may only have served to reinforce those lessons. Policy makers had responded with a renewed focus on the export-led growth strategy and accumulating foreign exchange surpluses and consumers moved towards saving even more. It actually increased its dependence on external demand, boosting the export share of pan-regional GDP from 35% in 1997 to 45% by early 2007.

Unfortunately, the lessons learnt, while important at that point in time, may now be coming in the way of the much-needed global macroeconomic re-balancing. China's imminent rise up the value-addition ladder and resultant increase in labor wages may be only another reason for these changes.

The prevailing global economic balance can continue only if the developed economies continue to exhibit the same insatiable appetite for imported goods from the emerging economies. In the absence of any such demand, the balance breaks down. Most worryingly for the emerging economies, their economies get imperiled if their major export market suddenly decides to take a holiday.

But re-balancing will require going beyond merely consuming more and saving less. Fundamentally, people will have to be convinced that they should spend more and save less. This becomes difficult, both on social-historic and economic grounds. Historically, people have been brought up in a culture of thrift and savings. Further, the deep uncertainty surrounding economic prospects in an increasingly globalized economy, without adequate social safety nets, only increases the urge among consumers to spend less and save more.

However, governments could help facilitate this process in many directions. Like with most issues affecting the world economy today, the major role has to be played by China. If China takes or is forced into taking three important steps, the world economy would have travelled a long distance in the path towards rebalancing.

1. Utilize a share of its massive "growth dividend" (taxes and other growth related revenues) to establish a comprehensive social safety net to cushion its vulnerable citizens. It would provide a boost to domestic consumption and lower the country's reliance on exports for growth. In fact, the recent fiscal stimulus was an excellent opportunity to establish this safety net.

2. Permit foreigners to invest in Chinese financial markets. This would immediately broaden and deepen the Chinese financial markets, thereby providing Chinese people themselves with a remunerative and diversified savings source. Besides, it would establish a channel for foreigners to take a share in China's massive foreign exchange reserves, thereby also ensuring diversification away from dollar-denominated assets and US Treasury Bonds.

Further, as China continues to increase its investments in global financial markets, it is important that foreign investors exposed to Chinese investments have access to appropriate instruments to hedge their China-related exposures. Foreign investments in yuan-denominated assets and yuan borrowings are therefore necessary requirements for the stability of the global financial system. This will also increase the global importance of the renminbi and enable China to play a greater strategic role in the world economy.

3. Permit a phased and calibrated re-valuation of the renminbi. Apart from rectifying the market distortions which adversely affect global trade, the benefits to China itself from this are manifold. It will immediately make imports competitive and benefit Chinese consumers and contribute towards lowering the emergent inflationary pressures. Chinese manufacturers will be encouraged into moving higher up the value chain and into more technology intensive goods, thereby increasing both their profits and critically labor wages. It will be a major step in the direction of boosting Chinese domestic consumption share and reducing the excessive export-dependence.

Interestingly, among all these emerging economies, India may be among those requiring the least amount of macroeconomic re-balancing. Its exposure to external markets, while significant, is more than off-set by its large share of domestic consumption, among the highest for emerging economies. However, a comprehensive social safety net, especially a national health insurance scheme, would be an example of both good social and economic policy.

Update 1 (29/9/2010)

Stephen Roach has these pro-consumption structural policies for China,

"These policies should include an expanded social safety net, with a public retirement program, private pensions and medical and unemployment insurance. China should also provide major support for rural incomes through tax policy and land ownership reform, as well as enhanced initiatives to encourage rural-urban migration. And it should encourage the creation of service-oriented jobs in industries like retail and wholesale trade, domestic transportation, leisure and hospitality."

China’s gross domestic saving rate is 54% of national income, the highest in the world for a major economy, whereas its consumption share of GDP is only about 36%, the lowest for a major economy.

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