Asia/Pacific: Discussions on the Global Imbalance
Andy Xie (Hong Kong)
morganstanley.com
I attended a conference on global imbalances and reforms of international financial institutions in Chongqing last weekend. China’s Ministry of Finance and the World Economic Forum, sponsored by Morgan Stanley, organized the conference in conjunction with the annual G-20 conference. The participants included senior central bank and ministry of finance officials from most of the G-20 countries.
Most western participants believed that Asian revaluation and a reduction in the US fiscal deficit would solve the global imbalance – a euphemism for the large and rising US trade deficit. Asian participants did not like the revaluation idea but thought the reduction in the US fiscal deficit was important.
I presented the case that the primary cause of the global imbalance was that major central banks, the Fed in particular, had ignored globalization when setting their monetary policies. Multinational companies have created a global supply platform after 15 years of global expansion. The elasticity of domestic supply to demand has declined sharply. Hence, when the Fed stimulates US demand, it leads to a rapidly rising US trade deficit.
The demand spillover from US monetary policy falls disproportionately into China as the lowest cost producer in the world and the first in line to supply US demand. When money reaches China, it turns into fixed investment because of the state-owned financial system. The investment boom in China increases oil prices.
Rising oil prices are redistributing income to the tune of US$400 billion per annum at present. The oil exporters hoard the oil windfall, correctly assuming that high oil prices are not sustainable. As Asia and Europe are unwilling to accommodate the higher trade surpluses of the oil exporters, liquidity from the oil windfall eventually flows to the US and, as US consumers are willing to spend any money they get, the US trade deficit rises to match the oil windfall. The Fed-China-oil linkage is the source of the global imbalance, in my view.
To rebalance the global economy, the Fed must increase interest rates aggressively to lower US consumption or China has to deflate its investment bubble by cracking down on speculation. Oil prices have to fall sharply to make global rebalancing possible. An Asian revaluation would only work by creating inflation in the US, which would force the Fed to raise interest rates aggressively. When US consumption declines, Asian currencies should depreciate again. To avoid this painful round trip, why doesn’t the Fed raise interest rates aggressively now?
The Contradictions within the Consensus
Most analysts agree that the extravagance of the US consumer is the fundamental cause of the global imbalance. However, Asian revaluation (i.e., Chinese revaluation) and reducing the fiscal deficit by the US federal government are usually recommended as the remedies for fixing the problem. At the Chongqing conference, some of the western advocates were quite emotional about both.
How can either measure restrain US consumption? If the US federal government decreases its deficit, this would depress aggregate demand. The Fed may stimulate again to make up for the shortfall. The US consumer would continue to spend as before, benefiting either from lower interest rates and/or higher asset prices.
An Asian revaluation could affect the global imbalance in two ways. First, stronger currencies could decrease exports from and promote imports into Asia. The US economy might benefit from more exports to Asia and import substitution to decrease its trade deficit. The appreciation of the yen or the euro, however, has had little impact on trade balances so far. The change in a country’s trade balance depends on its savings behavior and, without structural reforms, it is difficult to change Asia’s savings rate just through currency appreciation. Indeed, as currency appreciation may depress investment demand, the short-term effect would be to increase the trade surplus.
Second, Asian revaluation is an inflation shock to the US. It may force the Fed to increase interest rates aggressively, which would depress asset prices and force the US consumer to save more to offset the wealth shortfall. This would be a normal adjustment to lower the current account deficit. Southeast Asia and Korea did it in 1997 and 1998. Argentina, Brazil, and Russia have undergone similar experiences.
The difference between the US and emerging economies is that the US cannot export out of its problem through weakening its currency. The US economy is such a big player in the world that its devaluation strategy would backfire as it would depress demand in the rest of the world. So asset prices have to drop even further in the US to depress consumption sufficiently.
If the purpose of Asian revaluation is to force the Fed to raise interest rates aggressively, why shouldn’t it do this now? The roundabout way just creates more pain for everyone. I find the argument for Asian revaluation very confusing.
The Origin and Cure of the Global Imbalance
Fifteen years ago, the socialist bloc gave up on economic planning and embraced market economics and globalization. It injected an additional labor force into the global economy that was twice as big as the existing one. Multinational companies (MNCs) took advantage of the arbitrage opportunity and moved a big chunk of production to low-cost economies. This arbitrage process made the existing rich economies less prone to inflation. Hence, loose monetary policy could last without an inflationary backlash. The extra money would go into asset markets instead.
Anglo-Saxon economies made their economies more flexible in the 1980s. This flexibility made their asset markets more susceptible to monetary policy than those in either Europe or Japan. The Asian Financial Crisis was the turning point in this dynamic. The Fed eased aggressively in response to the deflationary pressure from Asia. It resulted in a booming stock market and triggered the tech bubble. The Fed loosened monetary policy further to fight the deflationary pressure from the tech burst in 2000. The policy became even looser with all the talk of unconventional measures that the Fed could use when the looming Iraq War exerted further deflationary pressure on the US and global economies.
The easy money pumped up US property prices and kept US consumption robust. Strong US consumption sparked China’s export surge, providing the funds for a strong investment boom. When the US government emerged to push the dollar down, financial investors bet against the dollar. Weak dollar expectations soon morphed into expectations of a Chinese revaluation, which triggered a torrent of money flow into China. China’s foreign exchange reserves increased by US$369 billion during 2003-04 (28% of 2002 GDP). China’s investment soared with the capital inflow, which triggered a surge in commodity prices, especially oil.
Rising oil prices redistribute income from all existing oil users to oil exporters. Compared to the average price in the 1990s, the oil windfall for Africa, Latin America, and the Middle East is around US$400 billion a year. Oil exporters correctly assume that current prices are not sustainable and hoard the income to smooth future consumption. But, as oil exports increase trade surpluses, the trade deficits of other economies have to rise. Consumption in Asia and Europe is just not flexible enough for savings rates to change quickly. Anglo-Saxon economies are very flexible and are capable of adjusting their savings rates quickly when given appropriate incentives. Such incentives would be rising property prices due to surplus liquidity from the oil windfall.
The liquidity from the oil windfall has not worked directly through the property markets of the Anglo-Saxon economies. The bearish sentiment towards the dollar has caused this liquidity to move to Asia, either directly or indirectly. Asia’s foreign exchange reserves increased by US$321 billion above its trade surplus in 2003 and US$335 billion in 2004 as hot money moved in to exchange dollars for Asian assets. Asian central banks assumed the risk on the dollar value and pumped the money into the US bond market.
The global imbalance is essentially due to the increased sensitivity of oil prices to global overheating. One way to decrease the global imbalance is for the Fed to withdraw its stimulus sufficiently to bring down oil prices. The alternative is for China to crack down on speculation, which would slow the money multiplier inside China, achieving the purpose of slowing the global money supply.
Reforming the IMF and the World Bank
Reforming the Bretton Woods institutions was a major topic at last week’s conference. Representation at and the mission and effectiveness of these institutions were discussed extensively. The developing and developed countries differed in their priorities. The developing countries demanded more representation at both, while developed countries were more interested in fine-tuning the mission for each and improving their effectiveness.
The big emerging economies were primarily interested in larger equity shares at the IMF. The background is that the IMF has not predicted their crises well and, when the crises arose, the IMF forced measures on the emerging economies that were too harsh and sometimes counterproductive. The emerging economies believe that they know better and want more influence on IMF’s decisions. The developed countries, I believe, think that it is their money and they must have the final say. The only common interest that seemed to be shared by developed and developing nations was to see a single representation of Europe at the IMF.
The representatives from western countries were far more interested in changing the focus of the IMF. One suggestion was that the IMF should supervise developed countries, especially the US, better. Most emerging economies are running trade surpluses and the Anglo-Saxon economies big deficits. The risks in the global economy have shifted to the Anglo-Saxon economies. Many participants at the conference felt that the IMF was inadequate in dealing with the current situation.
The delegates also questioned whether the IMF should be the lender of last resort. The resurging risk appetite in emerging economies could be related to the moral hazard behavior from the big IMF bailouts in 1998 and 1999. The IMF bailout in Indonesia, for example, subsidized capital flight and saddled the country with more debts. But no one could come up with a better alternative for solving emerging market crises.
The discussions focused little attention on the risks in emerging economies today. This reflects the fact that emerging economies have accumulated massive foreign exchange reserves while the Anglo-Saxon economies have massive trade deficits. When the global cycle turns down this time, we may not have a normal emerging market crisis. Instead, strong currencies, low interest rates, and low growth rates could be the characteristics for the emerging economies. |
