Perspectives from Around the World
Global Imbalances are Back!
Pier Carlo PADOAN
Deputy Secretary-General and Chief Economist, OECD
The debate about global imbalances usually refers to the large current account deficits and surpluses that co-exist around the globe. As such, they are not a new phenomenon. Already in the 1980s the United States was running a massive current account deficit, financed to a large extent by surpluses in Germany and Japan. This imbalance pointed to an overvalued U.S. dollar exchange rate--in part due to the mix of fiscal expansion and tight monetary policy of the Reagan administration--and was feeding into disquieting protectionist measures. This eventually led to a revival of international co-operation after it had fallen out of grace in the late 1970s, important manifestations being the Plaza (September 1985) and Louvre (February 1987) Accords to re-align exchange rates through intervention in exchange markets and the coordination of monetary policies.
The adjustment burden of global imbalances in those days initially tended to be borne by deficit countries alone. The view that surplus countries should adjust was heavily contested, typically by those countries identified as "best placed" to do so, notably West Germany and Japan. However, after monetary policy was eased in response to the 1987 stock market crash, a financial and real estate bubble began to develop in Japan, while a boom in real estate markets in Germany was prompted by positive money supply and confidence shocks associated with its reunification. Both popped in the early 1990s. Similar developments were seen in the Nordic countries, as well as in the United States, culminating in the Savings and Loans and LTCM crises.
Global imbalances largely disappeared from the radar screen in the 1990s, but this dramatically changed when emerging market economies entered the picture. Since the mid-1990s the world economy has become increasingly integrated, owing to the removal of trade barriers, the liberalisation of capital flows, the spread of new technologies and--last but not least--the fall of the Iron Curtain. World trade soared and cross-border flows grew from around 5% of world GDP in the mid-1990s to about 20% in 2007--the year preceding the global financial and economic crisis. External assets and liabilities as a share of world GDP more than doubled over this period, from 150% to 350%.
The case of China, now the second-largest economy in the world, deserves a separate mention. China's accession to the World Trade Organization (WTO) in 2001 represented a milestone in its engagement with the world economy. China has been running large current account surpluses while also attracting large inflows of foreign direct investment from the OECD area. Coupled with an exchange-rate policy of pegging the currency to the U.S. dollar and strict capital controls on capital outflows, this led to the build-up of over $3 trillion worth of foreign exchange reserves--almost 50% of GDP and one third of the global total. The bulk of China's official reserves have been invested in U.S. Treasury bonds, allowing the United States to finance its large current account deficit at favourable terms and to keep its bond yields low.
In addition, globalisation meant a massive increase in the global supply of low-skilled labour in the world economy, and this had substantial real-economy effects. Not only were emerging market economies now a major driver of global growth, they also kept inflation in the developed economies low via growth in cheap export products, economies of scale associated with integrated supply chains, and competition. Gradually this development was offset by the effect of buoyant demand on oil and commodity prices, but this was largely discounted as not being part of "core" inflation. In addition, in some OECD countries policy interest rates were systematically lower relative to the guidance offered by simple normative policy rules, such as the Taylor rule. In the context of malfunctioning and poorly supervised financial markets, this contributed to excessive risk taking and leveraging and, ultimately, the financial crisis.
The phenomenon of historically large current-account imbalances across the world is partly a reflection of high and rising commodity prices, in particular the oil price, leading to massive current account surpluses among the major oil exporters. But it can also be seen as a consequence of the globalisation of financial markets, with the home bias in financial investment largely removed. In principle, such a development is welcome to the extent it results in better international allocation of capital. This is based on the premise that normally capital "flows downhill," i.e. from high-income to low-income regions in the world where the marginal return on capital is highest. It would thus contribute to the convergence of per capita GDP across the world.
However, rather than flowing downhill, capital has been flowing uphill to a large extent, with emerging market economies massively investing in financial instruments issued by the advanced economies, notably the United States, attracted by its (supposedly) better quality of financial markets. Presently, downhill capital flows are gaining importance, as excess liquidity in the advanced economies is looking for yields in the emerging market economies. But paradoxically this may be too much of a good thing. Emerging market economies find it hard to absorb this capital properly. They face risks of Dutch disease (export squeeze due to appreciating real exchange rates), overheating, and instability.
Global imbalances eased in the aftermath of the crisis. Deleveraging prompted smaller current account deficits among many advanced economies. Policy stimulus to ward off recession along with a decline in primary commodity prices led to smaller current account surpluses among emerging market economies and commodity exporters, respectively. Even so, global imbalances are set to resurface. Commodity prices are recovering and emerging market economies are cutting back demand stimulus in the face of high inflation. The underlying propensity to save remains high among many emerging market economies, and in some advanced surplus economies such as Germany and Japan as well, while growing public indebtedness is boosting the demand for capital among advanced deficit countries--including in parts of Europe.
A risk associated with continued global imbalances in current account positions is that their unwinding could be disorderly--perhaps even more so now in the aftermath of the crisis than prior to the crisis. If biased towards deficit countries, the adjustment would slow the global recovery at a still delicate time. Fiscal stress in advanced deficit countries could prompt exchange rate and interest rate volatility. Protectionism could roar its ugly head. To prevent such damaging scenarios, surplus countries should allow a gradual but sustained real exchange rate adjustment and deficit countries should restore private and public balance sheets. International coordination could help to speed up this process.
The G-20 Framework for Strong, Sustainable and Balanced Growth has a useful role to play here, by seeking complementarities between macroeconomic and structural policies in the pursuit of global rebalancing. Possible avenues for structural policy contributions are: (i) the development of welfare systems and financial systems in the emerging market economises to stem the need for precautionary savings and relax borrowing constraints, respectively; (ii) pension reforms in advanced economies (increased retirement age to reduce savings propensities in surplus countries, lower replacement rates to increase saving propensities in deficit countries); (iii) product market reforms to encourage domestic investment in advanced surplus countries; and (iv) the removal of tax incentives for debt financing to encourage saving in advanced deficit countries.
While the crisis raged the gross capital flows from and among advanced economies collapsed. Gross capital flows have shown an incipient rebound in 2010, but the bulk is now directed towards emerging market economies. Past experience has shown that such capital flows can be a source of instability if they suddenly reverse. Banking crisis or currency crisis can easily ensue and cause longer term damage. This has been, by the way, the main motivation for many emerging market economies to "self-insure" against instability through the build-up of foreign exchange reserves. This, in term, prevents exchange rate adjustment, complicates monetary policy, and is relatively costly.
Therefore, it would be much better to develop structural solutions to stem the risk of instability associated with capital inflows. Specific reform options are multiple. The advanced economies should continue to deal with systemic risk such as the adoption of Basel III and tighter capital requirements for global systemically important financial institutions. They should also design and implement cross-border banking resolution schemes and monitor shadow banking and non-banks. Emerging market economies should promote more market based financial systems and develop local financial markets and open their capital account. They should also increase the quality of product market regulation and adopt less stringent job protection while boosting the quality of human capital. This is expected to increase long-term capital flows to emerging market economies along with a shift from debt to more stable foreign direct investment.
But such structural policies--useful as they may be--are unlikely to stem or change the composition of the ongoing short-run capital flows to emerging market economies. Soaring short-run capital flows to emerging market economies can be explained by the easy monetary conditions in the advanced economies--indispensible in view of their current fragility. Liquidity is hunting for yield, and where else would they be expected to do so than in the emerging market economies, given their--equally indispensable--tighter monetary conditions.
Recent work has suggested that apart from letting the exchange rate bear some of the brunt of the adjustment, macroeconomic policies constitute a first line of defence. Emerging market economies could pursue a counter-cyclical fiscal policy so as to take off some of the pressure. Macro-prudential measures may be a second line of defence insofar as they may prevent capital inflows from generating a domestic credit bubble with associated financial fragilities. Only as a third line of defence should one consider capital controls. The acceptance of capital controls as the last line of defence comes, however, with certain risks. To be specific, capital controls are politically more convenient to use than the first lines of defence--they can in effect become a cover for inappropriate macroeconomic policies. Capital controls can also entail distortions. And capital controls keeping out capital flows in one country may spill over elsewhere.
To prevent such adverse effects of a proliferation of capital controls it might be good to have some international surveillance process that establishes procedures and creates transparency about countries' policies. The OECD has a set of Codes concerning capital account policies. While the end-goal is free capital movements, the codes allow countries to set reservations on specific items and also allow them to become more restrictive if needed. But they will have to come and explain to other countries what they are doing, and having such a transparent process may help to establish some discipline. The OECD Codes may be useful as a source of inspiration, but have in any case recently been opened to adherence by non-OECD countries.
More fundamentally, mechanisms need to be found to allow different policy settings to co-exist across the globe in a way that promotes economic stability and growth. This will require international co-operation, surveillance and communication in setting priorities and in minimising any potential adverse side-effects that can arise from the resulting geographical constellation of policies. One aspect of this is the international effort under way to strengthen prudential frameworks around the world. Beyond this, the role of the G20 Framework for Strong Sustainable and Balanced Growth is to identify a combination of macroeconomic, structural and exchange-rate policies that strengthens growth prospects and helps to achieve more sustainable fiscal positions, whilst minimising the risks of a renewed widening in global imbalances.
Co-operation is also necessary if the international monetary system is to be strengthened. Eventually, real exchange rates will move in line with policy differences as well as different growth rates, inflation, and fiscal positions. Specifically, over time it would be expected that emerging market economies would experience a real appreciation. If the nominal exchange rate is fixed, the required changes have to come through adjustments to wages and prices, which can be costly as it would risk de-anchoring inflation expectations. Persistent currency misalignments in the interim can generate unsustainable external imbalances. Hence reforms are needed to facilitate the movement of exchange rates in line with economic fundamentals so as to ensure that nominal exchange-rate adjustment acts as a safety valve. On the other hand, excessive exchange-rate volatility can also have its costs.
To sum up, global imbalances remain at the forefront of our preoccupations. There are essentially three major challenges: two structural, one cyclical. The first structural challenge is to increase the net savings of several major advanced economies and to reduce that of the surplus economies, including (but not exclusively) in emerging market economies. To achieve this, emerging market economies need to develop their social welfare systems and deepen their financial markets while incentives for leveraging in some major advanced economies should be eased.
The second structural challenge is to secure a stable gross flow of capital from advanced economies to emerging market economies. This remains essential for global convergence, though it must be financed to a greater extent by domestic savings in advanced economies now running current account deficits. This requires inter alia a further opening of capital accounts and better quality product market regulation in emerging market economies. The short-run challenge is that abundant liquidity in advanced economies is hunting for yield in emerging market economies, where it can generate Dutch disease, overheating, instability, and protectionism. This should be tackled by a combination of exchange rate adjustment, counter-cyclical fiscal policy, and micro- and macro-prudential tools. Capital controls should be seen as a last resort.
July 1, 2011
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July 1, 2011［Perspectives from Around the World］