BEFORE THE GLOBALl financial crisis exploded a year ago, a major issue of concern to investors was how global imbalances would be resolved. Once the worst economic and financial crisis since the 1930s broke out, such concerns receded into the background. With recovery now appearing to take firmer root and with growing concerns over the US dollar, will concerns over these global imbalances return to haunt financial markets?
The term “global imbalances” refers to the huge external deficits of the US and some European economies as well as the outsized external surpluses that China, several of its Asian neighbours and the oil exporters enjoy. Such external imbalances are the product of savings and investment behaviour: If a country saves little but its companies invest heavily, that country will tend to have a current account deficit. The fear was that the US had too low a savings rate and that it would not be able to sustain such a large external deficit for too long. Continued large deficits meant a growing debt burden — something that could not go on for long before even the US’ capacity to repay debt or the sustainability of the USD as a reserve currency came under a cloud.
FIRST THE GOOD NEWS…
Since the Great Recession started, these external imbalances have been falling. From a recent peak of US$205 billion ($284 billion) a quarter in 3Q2008, the US current account deficit has fallen to US$99 billion a quarter in 2Q2009 and will probably fall more through year-end. On the other hand, the Chinese current account surplus has also fallen, albeit more modestly, from US$192 billion in 1H2008 to US$134 billion in 2H2009. Some may argue that this fall is more cyclical than structural and that, as soon as the US economy begins to grow again, its external deficit will rise to previous levels. We would say that there have been some fundamental changes that probably mean the reduction in these imbalances is structural and permanent:
- First, the household savings rate in the US is rising and there is every reason to believe that this is structural, not a temporary blip: American families no longer have the luxury of rising home prices that helped them increase their wealth effortlessly. They now must save to build enough reserves for their retirement. Moreover, the days of easy money that encouraged Americans to spend loosely and save less are over. With the unemployment rate likely to remain high for many years to come, US households will become more cautious and raise their savings rate even higher over the next few years. That alone should help reduce the US current account deficit;
- Second, just as its savings rate rises, the US’ investment rate is likely to at least edge down. Investment in residential and commercial structures will fall for some time, given the large inventory of unsold homes and the rapidly worsening vacancy rate in commercial property. US companies are also burdened by underutilised production capacity and, so, are unlikely to invest in new plant and equipment for some time to come. This will further reduce its external deficit;
- Third, the US is regaining its export-competitiveness, something that will become more evident in coming years. Although the USD has been volatile, its overall trend has been down. A depreciated USD will support increased US market share of global exports. More than that, US companies are restructuring ferociously, squeezing costs down — this will enable them not only to expand exports but also to compete more effectively against imports in their own home market. As exports rise and imports fall, the US external deficit should improve; and
- Fourth, China too is working hard to address the underlying causes of its excessively large external surplus. Chinese policymakers are introducing reforms to reduce the costs of medical care and education, allowing Chinese families to save less for these reasons. China is also introducing social safety nets — improving retirement pensions as well as introducing some form of unemployment benefits — which should help further reduce the household savings rates. In addition, China is planning to compel its huge state enterprises to pay dividends to the state: One reason China’s national savings rate is so high is that state enterprises save most of their profits and do not pay dividends to its shareholders (mainly the state). These reforms will take time to take effect but, over the next few years, we should see the Chinese savings rate falling and, so, helping to reduce its external surplus.
If we are right, then, enough changes are likely in China and the US to allow a sustained improvement in global imbalances of the sort that financial markets have been concerned about for a while. Not only will this reduce a major risk in the global economy, it will also eventually take some pressure off the USD and reduce the risks of a full-blown rout of the USD.
…BUT NOW THE BAD NEWS
All this is to be welcomed but it is, alas, not the entire picture. At the heart of the above global imbalances was a fundamental problem that has not been solved: Each major economy conducts monetary, fiscal and other policies that seem optimal from that country’s own perspective. That used to be just fine, but not in today’s globalised world, where economies are interconnected in so many ways and where massive amounts of capital flow in an undisciplined manner. In such a world, policies that were optimal for each country individually end up being bad for the global economy as a whole.
For example, in the run-up to this crisis, the US and Japan pursued monetary policies that were loose so as to address concerns in each of their economies. For its part, China pursued a policy of pegging its renminbi to the USD, which also made a lot of sense — to China. But, the net result of such policies was ultra-easy liquidity conditions that contributed heavily to the global crisis we endured in the past year. Cheap money in the US and Japan fuelled carry trades that inflated the prices of assets, creating bubbles that eventually burst. That was aggravated by Chinese savings surpluses, which grew hugely on the back of a super-competitive renminbi. These surpluses were invested in US bonds, which depressed long-term interest rates that aggravated asset inflation and bubbles.
Nothing has been done to reform the international system to prevent this anomaly of countries’ individual policies interacting to create problems. As long as there is no effective coordination of policies by the big economies, we can be sure that new global imbalances will build up over time and these will eventually cause bubbles or other forms of financial instability.
For example, there is now substantial excess liquidity around the global financial system. As the global crisis recedes and investors’ appetites for risk expand again, much of this excess liquidity will move into emerging-market assets. Since emerging markets are now investors’ favourite theme, the expansion of emerging-market valuations may well be substantial. Of course, in the short term, this will be wonderful for investors as valuations in emerging market bonds, equities and real estate soar. But, we know such liquidity- induced asset bubbles rarely last. Eventually, the emerging-market bubble will also burst — and even more problems in its wake.