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Research: For external imbalances, globalization is a double-edged sword

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
July 2005
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The large and rising U.S. current account deficit, and the corresponding surpluses in Japan, the emerging market economies of Asia, the oil-producing countries of the Middle East, and other countries, have led to mounting concerns that these imbalances are unsustainable, and that an abrupt depreciation of the U.S. dollar may occur, with possibly disruptive effects on the global economy. Not all observers are equally concerned, however, and some have argued that today’s deep international economic and financial integration makes a benign resolution of the imbalances more likely. The Spring 2005 World Economic Outlook (WEO) takes a closer look at this controversial issue and finds that globalization can facilitate global rebalancing if investor confidence is maintained, but can increase the risk of disorderly and costly rebalancing if the adjustment is abrupt. Thomas Helbling (IMF Research Department and coauthor of the WEO study) summarizes the findings.

Globalization affects external adjustment through a number of channels, among them, international portfolio diversification, exchange-rate-related valuation effects on assets and liabilities, and trade.

Increasing international diversification. Globalization affords improved opportunities for international financial diversification. Recent data indicate an increased willingness by investors to hold foreign assets. This decline in the “home bias” in asset holdings matters for external imbalances and their adjustment because it means that large sustained current account surpluses or deficits increasingly tend to be accommodated by international financial markets (see chart). Growing international diversification can also facilitate adjustment by allowing a gradual rather than abrupt rebalancing, avoiding the sharp changes in exchange rates and interest rates that occur in a disorderly adjustment.

The catch is that net external positions, which have grown greatly in recent years, may continue to increase substantially in the early stages of a rebalancing. This further raises external financial vulnerabilities if policies are not consistent with a credible medium-term policy framework aimed at external and internal balances. Investor confidence could then be undermined, leading to abrupt portfolio adjustment and disruptive financial market turbulence. With larger external positions, these risks are likely to be more elevated now than in the past.

Exchange rate movements and the value of assets and liabilities. Financial globalization also affects adjustment through the effects of exchange rate movements on the market value of external assets and liabilities. With assets and liabilities much larger than in the past, these effects can be large. Perhaps paradoxically, such “valuation effects” can in some instances facilitate external adjustment among industrial countries, as they are, in effect, wealth transfers from countries with appreciating currencies to countries with depreciating currencies. For example, valuation adjustments associated with the U.S. dollar depreciation in 2003—the latest year for which data are available—lowered the value of outstanding U.S. net external liabilities by almost $400 billion. Thus, despite a current account deficit of 4.8 percent of GDP, U.S. net external liabilities increased by only 0.9 percent of GDP. The counterpart was valuation losses by investors in countries with appreciating currencies.

Trade effects. With real globalization, trade integration has advanced rapidly, most notably in emerging markets in recent years, and the global distribution of trade flows has become more equal (see table, page 197), which helps adjustment through wider burden-sharing. As the WEO study cautions, however, globalization does not appear to have affected other key adjustment parameters. In particular, the overall tradability of goods and services does not seem to have increased despite declining trading costs. Why? The tradable sector’s share in output in most industrial countries has actually fallen slightly in recent years because of the rapid expansion of service sectors. Similarly, trade flows do not appear to have become more responsive to price and demand conditions, suggesting that adjustment still requires important changes in prices, demand conditions, or both.

Accommodating imbalances

Industrial current account balances have become larger in an environment where investors increasingly diversify their portfolios internationally.

(percent of GDP1)

Citation: 34, 12; 10.5089/9781451938685.023.A012

1In absolute values—that is, negative balances in percent of GDP are reflected as positive numbers.

Data: IMF, World Economic Outlook, April 2005.

Trade integration has grown rapidlyA more equal distribution of trade flows helps adjustment.
Origin
Emerging AsiaEuro areaJapanRest of worldUnited States
Destination1984200319842003198420031984200319842003
Exports1
Emerging Asia0.160.400.340.590.490.890.230.37
Euro area0.180.650.120.162.372.650.310.31
Japan0.280.450.060.110.160.210.190.14
Rest of world0.270.412.192.960.420.241.031.18
United States0.470.930.380.570.490.321.401.85
Total1.202.442.794.041.371.314.425.601.752.00

Extraregional exports as a percent of GDP.

Data: IMF, Direction of Trade Statistics, and International Finance Statistics; and IMF staff calculations.

Extraregional exports as a percent of GDP.

Data: IMF, Direction of Trade Statistics, and International Finance Statistics; and IMF staff calculations.

Globalization and the adjustment calculus

Overall, then, what are the combined effects of real and financial globalization on the adjustment of global imbalances? To analyze this question, the WEO research team used the IMF’s new multicountry Global Economy Model, developing a four-bloc version that broadly mirrors the geographical constellation of the current imbalances among the United States, the euro area plus Japan, emerging Asia, and the rest of the world. Two scenarios were considered: gradual adjustment and more abrupt adjustment.

In the gradual rebalancing scenario, the study traced how real sector globalization would affect the adjustment path, assuming a moderate fiscal adjustment about the size proposed by the U.S. administration (in this, U.S. net external liabilities as a share of GDP eventually have to stabilize in the long run, while the U.S. current account deficit narrows to a lower level consistent with this steady level of liabilities).

The simulations highlight the fact that the fundamental adjustment patterns during rebalancing have not changed with globalization. In particular, the simulation finds that the narrowing of the U.S. current account deficit is the result of a combination of higher U.S. real interest rates and higher U.S. saving ratios—reducing domestic demand—on the one hand, and a significantly weaker U.S. dollar—boosting net exports—on the other hand. In the other blocs, the rebalancing involves opposite adjustment patterns.

What has changed with globalization is that some key variables have to change less during adjustment, making it less costly. In particular, with globalization, external adjustment can be achieved with a smaller real depreciation of the U.S. dollar and smaller real appreciations in the other blocs, and with smaller increases in real interest rates in the United States and elsewhere. As a result, globalization generally allows the adjustment to occur with smaller short-run declines in output growth.

But what if the adjustment is not gradual? For its second set of simulations, the WEO team examined how adjustment unfolds if investor preferences change rapidly—that is, if investors are unwilling to continue accumulating U.S. assets for a considerable period. In this instance, net capital flows to the United States slow sharply, requiring a more abrupt adjustment in the U.S. current account. Correspondingly, U.S. interest rates rise relative to the earlier scenario, the U.S. dollar has to depreciate sooner and more sharply, and U.S. output slows more markedly.

The silver lining in this scenario is that real interest rates outside the United States fall, and—despite slower U.S. growth—GDP growth in the rest of the world rises moderately. This partly reflects the fact that the decline in desired asset holdings in the rest of the world is accompanied by a reduction in desired savings, which boosts consumption. In practice, however, demand outside the United States could fail to pick up—for example, because of adverse confidence effects—and GDP growth would be correspondingly weaker.

In sum, there is potentially good news and bad news. Globalization has created scope for less costly global rebalancing if financial market conditions remain favorable and investors continue to accumulate U.S. assets. The larger net foreign asset positions, however, raise the stakes considerably should there be sharp and unexpected changes in investor preferences. As the simulations underscore, a timely and orderly resolution of global current account imbalances remains a pressing concern.

Copies of the April 2005 World Economic Outlook are available for $49.00 each ($46.00 academic price) from IMF Publications Services. The full text of the latest issue of the World Economic Outlook is also available on the IMF’s website (http://www.imf.org).

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