Global: Rebalancing Interrupted
morganstanley.com
Stephen Roach (New York)
The dollar has reversed course and now looks like it wants to go higher. So much for the relative price change that a lopsided world needs more than ever. The pain of currency adjustment appears to be too much for the Europeans and the Japanese, and a poor and rapidly reforming Chinese economy is unlikely to lead the next phase of the dollar’s realignment. At the same time, the pain of a real interest-rate adjustment doesn’t fly in the United States. At least that’s the verdict of the markets and the America’s central bank. And so the heavy lifting of global rebalancing has been put on hold — at least for now. The key question is for how long?
History tells us that the rebalancing of a lopsided world economy is inevitable. Current-account adjustments should be expected when external deficits reach about 5% of GDP — precisely the threshold where the United States currently stands (see Caroline Freund, "Current-Account Adjustment in Industrialized Countries," Board of Governors of the Federal Reserve System, International Finance Discussion Paper No. 692, December 2000). That same history also suggests that current-account adjustments are driven largely by two significant changes in the asset price structure of the deficit nation — a currency depreciation and an increase in real interest rates. Specifically, the Fed study found that the average current-account adjustment has been accompanied by about a 20% depreciation in the real exchange rate (27% in the case of the US in 1985-87) and by a backup in real short-term interest rates that typically exceeds 100 basis points. The theory behind these interrelated price adjustments is not hard to fathom: Central banks typically use monetary tightening to defend against the excesses of a currency correction; a similar response can then be expected at the intermediate to long end of the yield curve, as foreign investors providing the capital to a deficit economy demand higher returns as compensation for taking excessive currency risk.
So much for history. To date, the price changes associated with America’s current external adjustment have fallen far short of historic norms. At its low point in January 2004, the broad trade-weighted dollar index had fallen by only 13% in real terms over the past two years. Over the same period, US real interest rates have been relatively stable.
In both cases — currencies and real interest rates — the authorities are now drawing a line in the sand. On the currency front, while the US seems perfectly content to let the dollar keep falling, Japanese and European authorities do not. The Japanese have intervened on an unprecedented scale — some US$184 billion of dollar purchases in 2003; moreover, the Japanese government’s supplementary budget for FY2003 provides for an additional ¥21 trillion (US$200 billion) funding for currency intervention, following the previously approved ¥79 trillion (US$750 billion). At the same time, leading European politicians — namely, German Chancellor Schroeder and French Prime Minster Raffarin — have now gone public in their displeasure over the recent strengthening of the euro. Partly as a result, pressure is building on the ECB for either direct intervention in foreign exchange markets or a rate cut. Meanwhile, despite America’s newfound economic vigor, America’s Federal Reserve seems determined to keep interest rates low for as long as possible. In short, no one really wants to bear the burden of global rebalancing.
By leaning against market-driven currency and interest rate adjustments, the Authorities are, in effect, short-circuiting the very price changes that an unbalanced world needs. Two possible rationales come to mind: First, there may be a belief in official circles that imbalances simply don’t matter in an increasingly interdependent era of globalization. The “goods for bonds” contract between Asia and America certainly gives some credence to this possibility, as ever-widening US trade deficits are effortlessly financed by Asian central banks who wish to keep their currencies competitive and their economies well-supported by export-led growth dynamics. A second possibility is that the authorities are simply seeking an easier and less painful way out — one driven by the upside of the global growth cycle. The trick in this case, of course, lies in the mix of global growth: At this point in time, any recovery in the world economy needs to be synchronous at a minimum, and preferably skewed in favor of the non-US portion of the world. By contrast, another burst of US-centric global growth would be self-defeating — it would only exacerbate America’s record trade deficit and thereby put even greater pressure on the very currency and real interest rate adjustments that the authorities are trying to avoid.
My guess is that both motives are at work. It’s not that the authorities truly believe that imbalances don’t matter — it’s just that they are doing everything in their power to shore up asset markets and push that moment of reckoning as far out into the future as possible. The verdict from ever-ebullient financial markets certainly offers encouragement in this regard. Meanwhile, there’s also hope that even more time can be bought by the upside of the global growth cycle. After all, history also tells us that there is a strong cyclical pattern to current-account deficits — they tend to get worse in recession and better in recovery. Yet the cyclical improvement of external imbalances is normally facilitated by the currency and real interest rate corrections described above — adjustments that tend to lower the import content of any cyclical rebound in economic activity. To the extent that those price adjustments are curtailed and that growth in the rest of the world continues to lag, cyclical improvement in America’s gaping current-account deficit could end up being very disappointing.
But there’s an even bigger catch to this story — the ever-mounting pitfalls of a saving-short, asset-driven US economy. This is the fundamental imbalance that brings currencies and real interest rates into play. And it is not going away in any short order. That’s because America’s gaping current-account deficit is largely a by-product of a record shortfall in domestic saving — in this case a net national saving rate that fell to less than 1% of GDP in 2003. At work are the twin forces of public sector profligacy and a private sector that now believes asset markets are a new and permanent source of saving. As long as saving-short America is governed by the same saving-investment accounting identity that underpins any macro system, it has no choice other than to import surplus saving from abroad in order to sustain economic growth. Pressures on the dollar and real interest rates are unavoidable in such a context.
This is where the politics of global rebalancing enter the equation. In this case, it’s more of a political backlash to the market-driven adjustments that such rebalancing entails. America is leading the charge in that regard. There’s no end in sight to Washington’s current penchant for deficit spending — especially in an election year. And a hiring-short and income-constrained private sector has become increasingly dependent on “wealth effects” as a replacement for earned labor income in driving personal consumption. Moreover, America’s central bank seems more than willing to cooperate in providing the interest-rate support that such an asset-driven US economy needs. All in all, the United States appears to have little or no political will to rebuild its saving shortfall.
Elsewhere in the world, the politics are also biased against the imperatives of global rebalancing. That’s especially the case in both Europe and Japan. To the extent that stronger currencies crimp the export growth dynamic in these two regions, support from internal demand becomes more urgent. That, in turn, puts the onus on reforms as the principal means to drive restructuring in labor and product markets and unshackle domestic demand. But that’s where economics also gives way to politics. Stronger currencies put pressure on job security in export businesses, and intensified reforms lead to headcount reduction in old businesses. Such job-related pressures run very much against the political will of regions that have deeply entrenched social contracts and are already suffering from sharply elevated unemployment. For Europe and Japan, that boils down to a steadfast political resistance against the economics of global rebalancing.
Unfortunately, the clash between the economics and the politics of global rebalancing has found a new and worrisome escape valve — an outbreak of protectionist sentiment. China bashing is at the top of this agenda, but threatened actions against India and the offshoring proclivities of global multinational corporations are also in this equation. Where this destructive aspect of the tale stops, no one knows. I continue to suspect the outcome will be very much dependent on the persistence of jobless recoveries in the wealthy nations of the developed world.
Whatever the source of macro tensions, one thing is for certain: The market-driven adjustments of global rebalancing are now meeting tough resistance in the political arena. To the extent that dollar and real interest rate realignments are short-circuited as a result, the imbalances of a lopsided global economy can only mount. In my view, that only makes the endgame far more treacherous — something that never seems to trouble ever-myopic politicians and politically sensitive central banks until it is too late. |
