Chapter

CHAPTER 10. Comments on Dealing with Global Imbalances

Author(s):
Il SaKong, and Olivier Blanchard
Published Date:
July 2010
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Author(s)
Justin Yifu Lin and Mansoor Dailami 

Few issues in international macroeconomics and finance have occupied the attention of policymakers and researchers in recent years as much as the debate on the causes, consequences, and measurements of global payments imbalances. To the extent that current account imbalances reflect the influences of underlying economic fundamentals such as differences in growth prospects, investment opportunities, demographic factors, and stages of economic and capital market development across countries, they can be considered “good” in the sense that their counterpart—net capital flows—serve to move capital from surplus to deficit countries. But this is where the consensus ends and the debate begins.

The debate on imbalances is multifaceted, encompassing both the national macroeconomic policy disparities that generate the imbalances and the political economy of balance of payments adjustment in the contemporary environment of shifting global growth balance, a changing geopolitical landscape, and growing national anxiety about employment and job prospects. The fact that the distribution of imbalances is heavily concentrated in two of the world’s largest economies, the United States and China, has raised the potential for policy tension and systemic risks, if for no other reason than placing the U.S.—China bilateral relationship at the center of the debate.

A recent paper by Blanchard and Milesi-Ferretti (2009) is a timely contribution not only to the global imbalances debate but also to the broader issue of balance of payments financing and adjustment that has engaged the international economic policy community since the establishment of the Bretton Woods institutions in 1944. It also makes the case that the recent narrowing of imbalances is underpinned by several factors that are likely to be transitory, while other factors remain that are likely to have a more enduring impact on lowering global imbalances. Indeed, some of the underlying distortions that led to the imbalances we see today not only remain in play but now threaten to derail the global recovery. Even with economic indicators improving and policy normalization beginning to take hold in many emerging market economies, the sustainability of the recovery is very much in doubt: sovereign risk is on the rise, while a multispeed global economic recovery portends increasing international policy tension over which countries must shoulder the burden of adjustment of large global macroeconomic imbalances.

Finally, Blanchard and Milesi-Ferretti (2009) reiterate the IMF’s long-standing concerns about the evolution of global imbalances since the mid-1990s, asserting that a multilateral approach to consultations on global imbalances served, in the precrisis period, to create a degree of consensus on policy measures. Changing patterns of saving and investment across countries have also been of long-term concern to the World Bank, and we believe the time is ripe for undertaking a new approach to global imbalances.

In this paper, we articulate an alternative point of view that looks beyond the traditional view of global imbalances (i.e., the critical role of U.S. macroeconomic policy on one hand and China’s exchange rate policy on the other). Rather, we develop a structural determinants view of global imbalances that recognizes the role of high corporate saving in China, the reserve currency status of the U.S. dollar, and the growth strategy of Asian emerging countries as part of the broader trend of the global economy moving toward a multipolar order. The structural manifestation of this move toward multipolarity is that a certain degree of current account imbalances across countries (and their counterpart capital flows) could serve both as a source of growth and a source of potential instability. The critical policy implication to be drawn from this alternative perspective is the need for a more nuanced approach to address global imbalances—one that more carefully weighs their current macroeconomic underpinning with longer-term structural determinants that will inevitably take longer to adjust.

An analysis of the record of global imbalances over the postwar era suggests that while payments imbalances have been a key feature of international economy, their patterns—and the way in which the international policy community has dealt with them—has changed considerably. In the immediate postwar years, when most exchange rates were fixed, cross-border capital mobility was restricted, and access to private sources of foreign capital was limited to a few high-income countries, while balance of payments imbalances remained relatively small and were managed through financing, primarily through official sources. The role of policy in this era was confined to coordinating what Webb (1991) refers to as management of the symptoms of incompatible national macroeconomic policies. But as capital markets have been liberalized and exchange rates made more flexible, balance of payments constraints on national economies have been considerably eased, thus facilitating larger payments imbalances, particularly in advanced economies with international currencies and developed financial markets such as the United States and the United Kingdom.

The present discussion focuses on three key areas: whether global imbalances pose a threat to global financial stability, what policy actions are needed to reduce imbalances and how effective such actions would be, and whether countries can be convinced to take such actions.

10.1. Are Global Current Account Imbalances a Threat to the Recovery or to Global Financial Stability?

The conventional view that global imbalances pose a threat to global financial stability through the mechanism of asset price bubbles depicts only one side of a complex relationship that is fundamentally structural in nature. Both global imbalances and asset prices react to the same force—the stance of monetary policy in reserve currency countries—that drive household wealth and consumption. In turn, patterns of household wealth and consumption are key determinants of the level of current account imbalances.

In the lead-up to the financial crisis, the world experienced an extended period of low inflation and increased globalization, the latter most evident in the sustained opening up of the Chinese economy and the rapid assimilation of the former planned economies of Europe into the world economy starting in the early 1990s. In an environment of low inflation, central banks were able to keep interest rates at low levels without fear of inflationary consequences. Low inflation and interest rates, along with regulatory forbearance in the financial sectors of major advanced economies, resulted in excessive risk-taking creation and spectacular asset price appreciation in many markets. The ample liquidity created by this excessive borrowing was funneled back into asset markets, leading to near-euphoria about the growth of markets and overconsumption at the household level. In this environment of overvalued asset markets, poor lending and investment decisions stemmed from lax regulation as well as from overconfidence and euphoria associated with low interest rates and ample liquidity. What was missing in the popular view of the boom at the time it was happening was an appreciation of an element of structural vulnerability. Rather, prevailing conditions and risk perception induced individual household, firm, and investor behavior that were collectively not stable.

From the mid-1990s until 2007, a defining feature of global finance in developed countries was the escalating integration of the household sector into capital markets. In the United States, a combination of booming equity and real estate markets inflated household wealth from $40 trillion in September 2002 to $66 trillion in June 2007, an increase of 65 percent, while U.S. disposable income increased by 29 percent over the same period (Figure 10.1). Asset market exuberance was accompanied by excessive credit creation, made possible through low interest rates and the technology of asset securitization. This correlation between household wealth and income on the one hand and capital markets on the other was a significant departure from the tradition of U.S. income and wealth creation through employment. For many households, mortgage equity withdrawals became an important source of income, reaching 8.3 percent during the peak of the asset market bubble.

Figure 10.1U.S. household wealth and disposable income.

As U.S. asset markets boomed and household borrowing and consumption expanded, massive amounts of capital flowed into the country to offset a large, growing current account deficit. The dollar’s international reserve status and its safe haven characteristics, coupled with the country’s large and deep capital markets and developed legal institutions, allowed it to succeed in selling huge amounts of government and corporate bonds on international markets. As of June 2008, foreign holdings of long-term U.S. securities amounted to $9.46 trillion, or 18 percent of total assets outstanding. This success, however, did not remove credit risk or the risk that an abrupt loss of investor confidence could trigger a disorderly adjustment in U.S. asset prices and the value of the dollar.

Though the financial crisis has resulted in a considerable narrowing of global current account imbalances, they are likely to widen once again, particularly because many of the long-term structural factors that encourage such imbalances remain in play: a low U.S. national savings rate, dependence of Europe and Asia on the United States for aggregate demand, financial market and corporate governance weaknesses in China, unresolved regulatory weaknesses in the global banking industry, and the unique role of the U.S. dollar in global trade and finance. The key postcrisis difference, however, is dramatically expanded public debt and deficits in major advanced economies, as the financial rescue measures of 2008–09 have shifted leverage from the private to the public sector on a grand scale.

Though China’s aging population may keep household savings relatively high,1 the real driving force behind China’s high national savings in recent years is the growth of corporate sector savings (Figure 10.2). Distortions such as limited competition, corporate governance weaknesses, and under-taxation, along with advantageous bank financing for state-owned enterprises and firms in export-oriented sectors have led to high retained earnings, high profit concentration, and widening income disparity (Lin, Dinh, and Im, 2010). And though U.S. household savings have increased by about 2.2 percentage points of GDP since the start of the crisis (in part arising from the asset bubble bursting), the increase has been more than offset by deterioration in the government deficit of 7 percentage points of GDP. With the government deficit projected to remain high in the foreseeable future, U.S. demand for foreign financing will continue to be a key feature of the global economy for years to come.

Figure 10.2Structure of China’s national savings.

10.2. What Sorts of Policy Actions Are Needed to Reduce Imbalances? How Effective Would These Actions Be in Reducing Imbalances?

Seen from the contemporary perspective of globalized financial markets, policy responses geared toward promoting an orderly adjustment of global imbalances must not only address existing policy distortions, but also incorporate implications of the changing global economic and financial landscape. What is called for is a global response, grounded in multilateralism and cognizant of the fact that global payments imbalances are more than just trade imbalances and U.S.—China bilateral imbalances. At the peak of imbalances in 2006, the U.S. current account deficit ($803 billion) represented 60 percent of total world external deficits, while China’s current account surplus ($253 billion) represented 17 percent of total world external surpluses. In 2008, estimates for the United States and China were 44 percent and 23 percent, respectively (Figure 10.3). Other countries with large surpluses included Germany, $245 billion (13 percent); Japan, $157 billion (12 percent); Saudi Arabia, $147 billion, (7 percent); and Russia, $96 billion (7 percent).

Figure 10.3Global current account balances.

Moving forward, policymakers must focus on the medium-term strategy of rebalancing global aggregate demand, a process that will involve structural adjustment in both deficit and surplus countries. Undoubtedly, exchange rate adjustments can contribute to this reorientation. Currently, many emerging economies operate under some variety of managed exchange rate regime with limited convertibility on capital accounts and intervene quite actively to attenuate exchange rate appreciation in the face of uncertain export demand. Two distinct phases characterize recent movements in emerging currencies: first, a phase of sharp decline as the crisis led to a reversal of private financial flows to emerging markets; and second, from March 2009 to April 2010, distinct appreciation of those same currencies (Figure 10.4). Yet the renminbi, one of the two currencies at the epicenter of the imbalances debate, has exhibited a different pattern: after appreciating 17 percent against the U.S. dollar between July 2005, when the authorities moved to a managed floating regime, and July 2008, China abruptly halted its appreciation and reset the rate at a fixed 6.83 renminbi per U.S. dollar (Figures 10.4 and 10.5).

Figure 10.4Exchange rate movements in emerging markets before and after the crisis.

Figure 10.5Exchange rate movements in China and Asian countries with floating currency regime

(nominal).

*Index: Jan 1999 =100; **Simple average of nominal USD exchange rates of India, Indonesia, Malaysia, Singapore, and Thailand.

China’s policy of holding the renminbi stable since July 2008 corresponds with both intensification of the global crisis and the surprising strengthening of the dollar during the first 6 months of the crisis owing to its safe haven characteristics and the reversal of carry trades (McCauley and McGuire, 2009). From a regional perspective, one consequence of this change in policy is that it has broken the correlation between the renminbi and Asian currencies under a floating exchange rate regime, both in nominal and in real terms (Figures 10.5 and 10.6).

Figure 10.6Exchange rate movements in China and Asian countries with floating currency regime

(real effective).

*Simple average of real effective exchange rates of India, Indonesia, Malaysia, Singapore, and Thailand.

As the world’s preeminent global liquidity provider, the United States enjoys the advantage of running a current account imbalance without facing the financing constraints that would be imposed on other countries. The dollar’s unique role in global trade and financial transactions—reserve currency; currency of debt denomination; and medium of pricing of trade and commodities, including oil—gives it a degree of structural support unmatched by other currencies. The fact that each of these roles is structural means that shifting global dependence away from the dollar will require sustained effort. It is also important to recognize that trade competitiveness in China is not just a function of exchange rate, but also of the country’s massive amount of investment in infrastructure and human capital. A sharp depreciation of the dollar or sharp appreciation of the renminbi would not be desirable, particularly during the fragile period of global recovery.

Reforms such as expanding social insurance and strengthening corporate governance are efforts in China that could lead to a decline in corporate savings that would be helpful in reducing China’s excessive national saving rate, even though such measures require a medium-to long-term time frame to be implemented. Addressing financial fragility, for example, requires a reexamination of the financial regulatory framework both at national and international levels. In contrast, addressing regulatory failures and introducing cross-national financial policies that relieve the need for self-insurance through reserve accumulation are reforms that can be implemented more quickly and can be the basis for effective coordination on other policy actions. In all cases, the events of 2007–09 present a unique opportunity to reshape regulatory parameters on a global level, while recognizing national competencies in certain areas. But developing countries’ interests and stakes need to be kept in mind as the new battery of financial regulations is developed and implemented.

At the international level, measures to reduce the incentives or urge for emerging market economies to accumulate reserves would be helpful in reducing foreign demand for dollars and dollar-denominated claims. The debate on reserve accumulation has focused on the vast amassing of dollar reserves in China and other Asian countries, which view reserves as self-insurance against global economic shocks. But the phenomenon of reserve accumulation is not limited to Asia, or even to oil-exporting nations. Developing countries as a group (especially those that are commodity exporters) are now accumulating reserves at a far greater rate and on a much larger scale than advanced economies in the aftermath of the East Asian financial crisis in the late 1990s. Likewise, removing certain national policy distortions that have a significant impact at the international level—rigid exchange rate regimes, limited capital account convertibility, and lack of a viable international currency other than the U.S. dollar—could also contribute to an overall decline in global imbalances.

Furthermore, addressing global imbalances is likely to require adequately resolving developing countries’ concerns about their IMF representation and the conditions attached to emergency borrowing. Solutions such as enhanced swap and credit lines and reserve pooling arrangements will be successful only if they assuage both political and economic anxieties. Though the IMF’s 2009 effort to enhance global liquidity through the allocation of $283 billion in special drawing rights offers some help in alleviating the precautionary demand for reserve accumulation, more needs to be done, particularly because the effect on developing countries of a special drawing right increase is limited because of IMF country quotas.

10.3. From a Global Political Economy Viewpoint, Can Countries Be Convinced to Take These Actions?

The present is neither the first time the world economy has faced large external payments imbalances nor the first time that questions of balance of payments adjustment and burden sharing have engaged the international policy community so intensely. Postwar history is replete with such episodes. In the early 1980s, the United States, under the Reagan administration, embarked on a course of expansionary fiscal and tight monetary policy to support the country’s massive rearmament, a shift that was accompanied by considerable international debate. Politics was also a key element in President Nixon’s 1971 decision to take the dollar off the gold standard, a move that ushered in the collapse of the Bretton Woods system. In that case, domestic pressure from labor, along with a corporate America and a banking industry bent on expanding exports, facilitating foreign investment, and opening access to the growing offshore Eurodollar markets, were part of the prevailing political calculation involved in extricating domestic macroeconomic policy from the constraint of external commitments. And, just as now, these episodes featured tough international bargaining by policymakers alongside their recognition of the need for evolving sensible cooperative solutions in order to safeguard collective interest and preserve global financial stability.

On other fronts, the global political economy forces in play today are quite different from those of the 1970s or 1980s. For one, economic power and the distribution of financial resources are more multipolar. The growing influence of emerging economies, such as China, with very different development ambitions, resource bases, and political constraints than the United States and its traditional postwar allies, Western Europe and Japan, is also a factor. The rise of Brazil, Russia, India and China, emergence of the euro as a legitimate rival to the dollar, and much deeper global financial markets with growing South-South linkages have also altered the global political economy landscape significantly (Dailami and Masson, 2010).

Today, an exercise of monetary power that delays adjustment of imbalances or results in asymmetric distribution of the burden of adjustment is no longer a viable solution. That said, global payments imbalances are fundamentally structural and will take time to unwind. For U.S. policymakers, reducing the current account deficit to a level consistent with long-term growth in foreign demand for dollar liquidity and portfolio investment in U.S. assets would be a positive step (see Blanchard, Giavazzi, and Sa [2005] for an analysis of the role of foreign demand for U.S. assets). For China, moving toward capital account convertibility in a gradual and sequential manner would command high policy priority. For the world economy as a whole, reducing large excess capacity, which has an adverse impact on global investment and growth would be the most urgent challenge to address. All countries must be mindful of the interaction of economic policy across national borders. The abrupt correction of global imbalances brought about as the result of political pressure in deficit countries, for example, could worsen excess capacity and undermine the ongoing global recovery. In all cases, successful reining in of imbalances will be a global effort requiring strenuous measures by both deficit and surplus countries to use the crisis as an impetus to initiate necessary structural reforms.

10.4. References

    Blanchard, Olivier, FrancescoGiavazzi, and FilipaSa, 2005, “The U.S. Current Account and the Dollar,” NBER Working Paper 11137 (Cambridge, MA: National Bureau of Economic Research).

    Blanchard, Olivier, and Gian MariaMilesi-Ferretti, 2009, “Global Balances: In Midstream?IMF Staff Position Note.

    Dailami, Mansoor, and Paul R.Masson, 2010, “Toward a More Managed International Monetary System,” International Journal (forthcoming).

    Lin, Justin Yifu, HinhDinh, and FernandoIm, 2010, “United States-China External Imbalance and the Global Financial CrisisChina Economic Journal (forthcoming).

    McCauley, Robert N., and PatrickMcGuire, 2009, “Dollar Appreciation in 2008: Safe Heaven, Carry Trades, Dollar Shortage and Overhedging,” BIS Quarterly Review, December, pp. 8593

    Webb, Michael C., 1991, “International Economic Structures, Government Interests, and International Coordination of Macroeconomic Adjustment Policies,” International Organization, Vol. 45, No. 3, pp. 30942

China’s household savings, now at 22 percent of GDP, is just below that of India, which has a very young population. So the aging population cannot be the main reason for China’s high savings.

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