Apr 04, 2002
Global: On Current-Account Adjustments
Asia Pacific: Oil Chic
MTIP Markets: Winds of Change Finally Blowing
Global: On Current-Account Adjustments
Stephen Roach (New York)
Hints of America’s coming current-account adjustment are already in the air. As Joe Quinlan noted in yesterday’s Forum, just-released data on foreign capital inflows into the US for early 2002 point to a significant shift in the sources of external financing. In January, portfolio inflows into dollar-denominated assets slowed to just $11.3 billion, a marked deceleration from average monthly flows of $44 recorded during 2001. If this trend remains even remotely intact, I believe America’s ability to finance its massive external deficit will become severely impaired. And then the US current-account adjustment will begin in earnest.
What might such an adjustment entail? That’s a question I get a lot these days as I pound the table on what I believe is the key macro tension point for the US economy. Fortunately, there are important lessons from history that may shed some light on what the future holds for America as it faces up to the coming external adjustment. A recent research paper by a Fed economist provides some compelling evidence of potential responses as drawn from the experiences of some 25 current-account adjustments that occurred among industrialized countries over the 1980-97 period (see Caroline L. Freund, "Current Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System International Finance Discussion paper #692, December 2000, available at www.federalreserve.gov). While this history offers no guarantees of what lies ahead for the United States, there are some important lessons that I do not believe should be taken lightly.
First of all, the Fed study finds that the median current-account (CA) adjustment of these 25 episodes occurs when the external gap hits about 5% of nominal GDP. It then takes about three years, on average, for the adjustment process to run its course. Even after those three years, the median CA is still in deficit to the tune of about 1% of GDP. There is considerable variability within this sample as to which CA deficit threshold triggers the adjustment. The last time it occurred in the United States was in 1987, when the CA gap was 3.7% of GDP; three years later it had shrunk by 56% to 1.6%. There are, of course, many episodes of CA adjustments that predate the 1980 time frame. But the sample in the Fed study was restricted to that period largely because it had two key characteristics in common with current international financial conditions -- broadly based financial capital mobility and flexible exchange rates.
It’s the dynamics of the CA adjustment process as revealed in this Fed study that I find most fascinating and pertinent for the economic outlook. (Note: The results reported below are for the median CA adjustment over the 25 episodes contained in the 1980-97 sample period). First, the adjusting country typically experienced depreciation in its real effective exchange rate of about 20%; in only two of the 25 instances did the exchange rate appreciate -- Canada in 1981 and Denmark in 1988. But they were the obvious exceptions. Typically, the devaluation began about a year before the CA gap hit its peak and then continued for another three years. At the same time, the depreciation in the nominal exchange rate was, on average, more than double the decline in the real exchange rate. Second, real GDP growth slowed, on average, by about three percentage points from the year prior to the CA peaking; that impact was largest in the first year of the adjustment process. Third, short-term interest rates typically rose in the beginning of the CA adjustment as central banks attempted to limit currency depreciation; toward the end of the adjustment process, short rates typically fell as the downside of the business cycle played out.
Fourth, the Fed study found that an improved trade balance was an important by-product of most of the CA adjustments in this sample period. Interestingly enough, trade turnarounds were mostly export led, with real export growth being boosted, on average, by four percentage points over the course of the three-year CA adjustment. Import growth, by contrast, slowed quite sharply in the first year of the CA adjustment -- a four-percentage-point reduction, on average -- but then returned to its pre-adjustment trend two years later. Fifth, CA adjustments are typically more investment- than saving-led; national saving ratios change little over the first two years of the adjustment period, whereas aggregate investment ratios typically fell by close to two percentage points over the same period.
All this paints a pretty clear picture as to what to expect in the coming US CA adjustment -- a weaker dollar, slower GDP growth, a less accommodative Fed, firmer exports, and weaker imports and investment. It’s yet another manifestation of America’s post-bubble adjustment process. During the Roaring 1990s, Americans (especially consumers) took great confidence from equity wealth effects and drew down their income-based saving balances to historic lows. The result was a saving-short US economy that had to rely increasingly on foreign capital to finance its IT-led investment boom. And America had to run a massive CA deficit in order to attract that external capital. But in doing so, the nation lived well beyond its means -- as those means were defined by the domestic income generation associated with national production.
The coming CA correction suggests that this same movie is now about to run in reverse. In my opinion, it’s just a matter of when, not if -- and what triggers the adjustment process. Along those lines, there is great debate on whether the coming landing will be "soft" or "hard" -- gradual or abrupt. This is particularly problematic since the dollar is the world’s dominant reserve currency and the US is the world’s largest international debtor. Given the saturation of dollar-denominated assets in foreign portfolios, a crisis of confidence is not inconceivable. Should that occur, I believe a hard landing would be inevitable. The metrics of past CA adjustments has little to say about differentiating between these two possibilities. But one thing is certain: The longer the day of reckoning is put off, the more severe the macro impacts of the adjustment process are likely to be. That’s because CA adjustments are not complete until the deficit gets reasonably close to balance. In the 25 instances covered in the Fed study cited above, CA deficits ended up, after three years, being less than 2% of GDP on all but four occasions. In other words, there’s little dispute over the endgame. It’s just a matter of when -- and from what extreme -- it begins.
Needless to say, all this has important implications for financial markets. As I see it, two aspects of America’s looming CA adjustment should be especially important in that regard -- weaker GDP growth and a fall in the dollar. A shortfall in GDP growth implies a weaker earnings trajectory than most equity investors are assuming. And a weaker dollar should provide ample incentive for global investors to diversify out of dollar-denominated assets -- consistent with our global decoupling thesis. I remain convinced that America’s ever-widening current-account deficit is on an inherently unstable path. A correction is coming and there’s no dark secret as to what that means. It’s just a matter of when the denial finally cracks. |
