morganstanley.com
Sept 22, 2003
Global: Breakthrough
Stephen Roach (New York)
An unbalanced global economy has finally come to its senses. At the just-concluded G-7 meetings in Dubai, the world’s major industrial economies have endorsed the basic premise of global rebalancing -- a long overdue adjustment in the dollar. This could well have profound and lasting implications for the world economy. It is an unequivocally positive development, in my view.
Policy statements are always clouded with ambiguity. That’s true of central bank policy directives, as well as communiqués released after G-7 meetings. But for me, the communiqué from the 20 September G-7 meeting in Dubai was crystal clear. Three words said it all -- “flexibility” and “market mechanisms.” G-7 finance ministers have finally conceded that “…more flexibility in exchange rates is desirable for major countries or economic areas to promote smooth and widespread adjustments in the international financial system, based on market mechanisms.” In plain English this means that the perils of external imbalances -- massive deficits in America and surpluses in Asia and, to a lesser extent, Europe -- are now center stage. Market-driven currency adjustments are seen as the means to correct these potentially destabilizing external balances. This is a thinly veiled message to the Japanese, suggesting they cease and desist from their campaign of currency manipulation. It also puts other nations on notice who have been pegging their exchange rates -- especially China and its neighbors in Asia -- that there is no escaping the endgame of market-based principles of currency flexibility. But the essence of the message is that an unbalanced world now needs a weaker US dollar.
It’s worth underscoring how the world would benefit from an orderly depreciation of the dollar. From the standpoint of the United States, a weaker currency shifts the mix of economic growth from domestic demand to exports. Given America’s massive external financing needs -- currently more than $2 billion of capital inflows per business day -- foreign investors will probably need to be compensated for taking currency risk. That should result in higher real interest rates and a related suppression of domestic demand growth. Such an outcome will be key in enabling the US to rebuild national saving -- thereby weaning America from its increasing dependence on foreign saving and the current account deficits it needs to attract such capital from abroad. As an important aside, a weaker dollar will also be helpful in America’s anti-deflation campaign -- having the effect of transforming imported deflation into imported inflation.
Alas, there’s a certain zero-sum aspect to the global economy’s adjustment in relative prices. For the rest of the world -- or at least the major countries or regions that would have to bear the burden of the dollar’s correction -- the impacts are the mirror image of those facing the US. As the yen and the euro rise in response, export competitiveness in Japan and Europe will be diminished. That will force both economies to take actions aimed at promoting growth in long-sluggish domestic demand. Fiscal and monetary policies will need to be biased more toward accommodation than would be the case if the yen and the euro were artificially depressed. But the key impacts on Japan and Europe would be to accelerate the focus on reforms. Stronger currencies are the functional equivalent of “straitjackets” -- forcing nations or regions to unshackle domestic demand by making internal markets more flexible, businesses more efficient, and price-setting mechanisms more competitive. Without such reforms, there can be no global rebalancing.
Japan has long been a major stumbling block on the road to global rebalancing. Two reasons explain why it has now shifted its position -- economic growth and politics. The Japanese economy expanded at a 4.0% annual rate in 2Q03 bringing the year-over-year increase to 3.0%. On both counts, that qualifies Japan as the fastest growing economy in the G-7. While our Japan economics team looks for some weather-related consolidation in the current period, they now believe that a long-sluggish Japanese economy is on a moderate cyclical recovery path that could last through mid-2004. Meanwhile, Prime Minister Koizumi has solidified his political position, garnering 61% of the votes in the LDP leadership elections this past weekend, setting the stage for a solid general election victory in November. At the same time, he has reaffirmed his support for the principal reformer in his cabinet -- economics and financial services reform minister, Heizo Takenaka. With growth and politics moving into favorable alignment, this is a perfect opportunity for Japanese policy to shift focus away from currency manipulation to reform. With the yen now trading though the all-important ¥115 threshold against the dollar, it appears that the Japanese authorities have called off their campaign of aggressive currency intervention -- at least for the time being. There is no better time for the Koizumi government to seize the moment and get on with the heavy lifting of structural reform. For Japan, this could truly be its last chance.
For Europe, the basic message of the Dubai communiqué is inescapable: The imperatives of reform are about to become even more urgent. That’s not say Europe hasn’t made progress on this front over the past six months. That’s been the case in Germany, where Chancellor Schroeder’s government has not only accelerated the pace of tax cutting but has also moved ahead in proposing reforms of labor market regulations and social security. Meanwhile, the French government has withstood widespread protest and stayed the course on public sector pension reform; healthcare insurance reforms are next on France’s agenda. At the same time, there has been progress on Austrian pension reform and on Portuguese corporate tax reforms. At work have been the strictures of the Stability and Growth Pact, reinforced by the mounting pressures of a stronger euro. Global rebalancing offers no real let-up on the currency front, although the breakthrough in Dubai implies that some of the burden of the dollar’s adjustment will now be shifted away from Europe to Japan. But as the dollar’s correction gathers force, the pressures pointing to a stronger euro will not abate. That will keep the onus on reforms -- tough medicine over the near term but ultimately good news for Europe and for the hope of achieving better balance in the global economy.
The Dubai communiqué does not put explicit pressure on China and other developing nations to abandon currency pegs and adopt more flexible exchange rate regimes. I’ll be the first to admit that this conclusion is open to interpretation. But as I read the language of the latest G-7 statement, the reference is to currency flexibility in “major” economies -- a qualifier that is normally reserved for wealthy, industrial nations. I have argued at length why a developing Chinese economy should not be lumped in the same category as the developed economies (see, for example, my July 14 essay, The Scapegoating of China). The lack of well-developed financial systems and capital markets suggests that China and other developing countries are simply not prepared to cope with open capital accounts and the flexible currencies that more advanced nations can accommodate. China’s special outsourcing role in the global supply chain also argues against a revaluation of the renminbi. These considerations should not, however, be viewed as permanent. As China and other developing nations make progress on the road to reform and prosperity, currency flexibility can become a more realistic and important element of their growth strategies. In the end, there can be no special exemptions from global rebalancing.
For the US, Dubai was also a watershed event. The motivation is not hard to fathom. At work is an increasingly powerful interplay between economics and domestic politics, as America’s jobless recovery appears on a collision course with the Bush Administration’s re-election hopes. With America’s fiscal and monetary levers already fully engaged, the currency option takes on new and critical importance as the only means left to provide macro stimulus to a beleaguered US labor market. It remains to be seen as to whether such tactics will work -- especially with IT-enabled outsourcing creating a new and lasting global labor-cost arbitrage that biases US employment growth to the downside. But the Bush administration has evidently concluded that a currency adjustment needs to be added to America’s reflationary policy arsenal. In doing so, US politicians should benefit by having fundamental economics on their side, as America’s massive current account deficit screams out for a weaker dollar.
History tells us that the US dollar has only just begun its downward descent. On a broad trade-weighted basis, the dollar (in real terms) has fallen about 8% from its early 2001 highs. In a full-blown current account adjustment, a drop of around three times that magnitude can be expected -- not all that different than the 30% real deprecation of the dollar that occurred in the late 1980s when the current-account disequilibrium was far less acute. In the end, a lopsided world has no choice other than to accede to a weaker dollar. The G-7’s Dubai communiqué now puts the major economies of the world on the same page with respect to the global rebalancing that such a currency realignment can trigger. The road ahead will be long and arduous -- and not without risk, especially in oft-volatile currency markets. But the economics I practice suggest it is the only way out for such an unbalanced world. As someone with a long-standing gloomy bias on global prospects, I am now encouraged for the first time in four years. |
