Tuesday, January 18, 2011

Rebalancing global current account imbalances

The biggest medium-term concern for the world economy is the management of the global macroeconomic (specifically, current account) imbalances - getting the deficit countries to save and the surplus generators to spend more.

Joseph Gagnon feels that current account imbalances are likely to return to record levels over the next five years and the recent narrowing of imbalances was almost entirely a result of the global recession and that global recovery will unwind this effect. About the fundamental reason for the continuing build up of these imbalances, he writes,

"The primary culprit, in my view, is the development strategy increasingly being adopted by emerging markets — most notably China — of deliberately undervaluing one’s currency by official purchases of foreign assets in order to get net-export-led growth. Most developing economies are now piling onto this strategy in a big way (hence the currency wars), and it is a major problem for the U.S. We all want net exports to grow but we cannot all get it."

About the way ahead, he writes,

"To avoid a return of large global imbalances, economies with current account deficits should cut fiscal deficits more than is currently projected and economies with current account surpluses should reduce official financial outflows and allow their currencies to appreciate as well as take steps to boost domestic demand.

Fiscal consolidation in surplus economies — though necessary in some cases — is detrimental to rebalancing and should proceed at a slower pace and to a lesser degree than in deficit economies. Even in deficit countries, the pace of fiscal consolidation should be slower in economies where the recovery from the crisis remains weak.

Monetary policy should remain accommodative and even ease further in economies where output remains below potential and inflation threatens to fall below desired levels. In developing countries in which inflationary pressures are rising, a tighter macroeconomic policy stance is indicated. However, the form of the tightening should differ based on country circumstances: Surplus economies should tighten via exchange rate appreciation, whereas deficit economies should tighten via fiscal policy."

I am not sure whether Gagnon's assessment of the reasons and the possible solutions captures the full picture. While he offers clarity on the measures to be undertaken by the surplus generators, there is ambiguity about policies to be adopted by the deficit countries. He under-estimates the contribution of the extraordinary monetary accommodation (by way of quantitative easing) in the US to sustaining the imbalances. The resultant capital flows into emerging economies have played an important role in fuelling financial market excesses and over-heating there.

Monetary accommodation, while required to mitigate the adverse impact of the recession, cannot be a substitute to avoid the hard choices required. Given the extraordinary structural imbalances that had crept into the domestic economy (eg, the out-sized prominence of the financial markets), economies like the US cannot restore normalcy without undergoing considerable pain and implementing policies that can reform the domestic structural imbalances.

For a start, debt-laden household and business balance sheets have to contract considerably for any recovery to be sustainable. Currently, apart from boosting aggregate demand and investment, policy-makers are adopting an ultra-accommodative monetary policy for three reasons. One, keeping real interest rates low so as to lower the interest burden. Two, buy time for recovery to take hold by allowing businesses and households to re-schedule their debts. Three, hope that asset values will regain a major share of their values, so that some of the notional balance sheet debts will disappear.

However, all these assumptions may not stand closer scrutiny. Asset values are far down from the boom peaks and are not likely to return to anywhere near those values anytime in the foreseeable future. Further, buying time while keeping an ultra-accommodative monetary stance, may as Raghuram Rajan and others have argued, fuel other bubbles and even more asset mis-allocation. All this would be pumping more steroids on a patient already pumped up with an over-dose of them!

America's persistence with more quantitative easing in the name of expanding credit and lowering real long-term rates (and thereby raise asset values and boost consumption) is similar to China's policy of keeping the renminmbi under-valued so as to keep exports competitive. The Americans say that without this, the economy risks tipping into a deeper recession. The Chinese fear that currency revaluation will reduce Chinese exports, weaken economic growth, and generate social tensions. Both sides are grossly over-estimating the relative impacts and their policies are playing an important role in sustaining the current account imbalances. Further, both are band-aid policies that reveal a reluctance to embrace more fundamental changes required to remedy deeper domestic structural problems.

Micheal Spence has a few excellent suggestions, which may be germane to a more effective resolution of the imbalances. He advocates a pull-back from the quantitative easing policies and policies that increase the share of America's tradeable sector. He writes about,

"... a pull-back from quantitative easing in the US, which is subjecting the emerging economies to a flood of capital, rising commodity prices, inflation, and asset bubbles. Intervention may be needed in fragile sectors of the US economy, like housing, where faltering performance could produce another downturn. But such intervention can and must be far more precisely targeted than QE2. America’s reluctance to target areas of weakness or fragility leaves the impression externally that QE2’s real goal is to weaken the dollar...

global economy will be out of balance so long as the US runs large current-account deficits... that gap needs to be filled by higher foreign demand and increased export potential... The tradable sector accounts for just 30% of the US economy (by value added), and employment growth in the tradable sector is negligible... If exports are to grow substantially, the scope of the tradable sector must expand."

He also makes a subtle point about China's internal re-balancing,

"In the case of China, a key part of its 12th five-year plan is to shift income to the household sector, where the savings rate is high but still lower than the corporate rate. The economy can then use household savings (with appropriate financial intermediation) to finance corporate and government investment, rather than the US government."

Such internal re-balancing can be done only if China liberalizes its labor markets so as to remove restrictions on wage increases and puts in place a social security system to cushion workers against rising uncertainty (and this is one of the major causes for higher savings rate). It has to be hoped that such policies will encourage the Chinese consumers to loosen their purse strings.

1 comment:

Alexei Anisin said...

You make some strong points here. Good work.

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