RIETI Report June 2004

Designing a "Policy Mix": RIETI Policy Symposium Preview - No.2
<RIETI Special Interview> Li-Gang LIU

As the 21st century unfolds, new global imbalances are emerging with the U.S. current account deficits ballooning on the one hand and the current account surpluses of East Asian countries increasing on the other. RIETI will hold a Policy Symposium, "Resolving New Global and Regional Imbalances in an Era of Asian Integration," on June 17 and 18 at Keidanren Hall (Chiyoda-ku, Tokyo), to analyze the nature and sustainability of such new global imbalances and discuss some anticipated scenarios with regard to the process of imbalance adjustments. Ahead of the event, RIETI Report interviewed Dr. Li-Gang LIU - assistant professor of Public Policy and Finance, School of Public Policy, George Mason University - an expert on international trade and finance, and Chinese and East Asian Economies, who will be one of the presenters at the Symposium. (AK)

RIETI Report: To what extent can the Asian external surplus and foreign reserves accumulation finance the U.S. twin deficits and affect its financial market?

Liu: Collectively the Asian central banks, including Japan, have accumulated about $1.2 trillion of foreign exchange reserves, mostly in U.S. dollars. Almost half of them are used to finance the U.S. current account deficit, now about $500 billion or about 4.7% of U.S. gross domestic product (GDP). The Asian banks' holdings of U.S. treasuries have also created excessive demand in this market, thus depressing U.S. short-term interest rates. This is one of the factors that contribute to keeping the U.S. interest rates low for an extended period.

However, with the expectation that the U.S. is going to raise its interest rates in the near future because of the materialization of wage-led inflation, U.S. treasury holdings may become less attractive. But, the Asian central banks are not likely to switch their dollar holdings for fear that their own currencies may rapidly rise.

RIETI Report: What are the appropriate adjustment policy mixes for Japan and the U.S.?

Liu: The Japanese economy has recovered rigorously in the last year and a half largely owing to a combination of structural reform such as dealing with bad loans in the banking system and corporate restructuring, very accommodative monetary policy, and a favorable external environment, most notably the robust U.S. recovery and import demand from China. In particular, the dividend of domestic structural reform seems to have paid off: Japanese industries have become competitive again. In light of the current global imbalances, Japan could go further by taking in more imports from the rest of the world and acting as a locomotive of the world economy in addition to its already large contribution in terms of foreign direct investment (FDI) and financial investment in the rest of the world.

Faced with large twin deficits, trade and budget deficits, the U.S. economy will have to rebuild domestic savings and mitigate its large domestic savings-investment imbalance. This may require either cuts in government expenditure or the raising of taxes to reduce federal deficit. These policies will thus reduce U.S. domestic demand. As a result, its demand for foreign products will also drop. Because of Asia's reliance on the U.S. market, the Asian economies will need to stimulate domestic absorption via active fiscal and monetary policy. Indeed, this does not exclude exchange rate adjustment either.

RIETI Report: Another Plaza Accord? What policy initiatives should be taken by Japan and the rest of Asia?

Liu: To some extent, the rapid appreciation of the yen due to the Plaza Accord combined with accommodative monetary policy with an aim to stimulate domestic economy caused the asset bubble in Japan and its eventual burst thus led to a decade of economic stagnation. Other Asian economies, notably China, could run the risk of experiencing similar problems because of their still fragile banking system and unfavorable fiscal conditions. A large appreciation of Asian currencies does not seem to be desirable at this junction and thus may be unlikely. What the Asian economies could do instead is redirect their trade in exchange for a large collective appreciation, speed up regional integration through trade and FDI liberalization, and stimulate domestic demand by making their banking sector efficient at allocating domestic savings and nurturing domestic bond market developments.

To view the program for the RIETI Policy Symposium "Resolving New Global and Regional Imbalances in an Era of Asian Integration" and to register your attendance, please visit the website: http://www.rieti.go.jp/en/events/04061701/info.html


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Designing a "Policy Mix": RIETI Policy Symposium Preview - No.2
<RIETI Special Interview> Li-Gang LIU

Li-Gang LIUSenior Fellow, RIETI

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