Since the outbreak of the world financial crisis, global imbalances have taken centre stage in the debate on the causes of the financial meltdown and the global economic outlook (Suominen 2010, Claessens et al. 2010, Servén and Nguyen 2010). Here we take stock of existing views on the roots of global imbalances, and in light of them we assess different scenarios about the future of global imbalances and their potential consequences for developing countries.
The roots of global imbalances
At the risk of over-simplifying, we can distinguish two basic views.
- The first emphasises international asymmetries in the supply and demand for goods – some countries (with the US at the top) spend too much, while others (e.g. China) spend too little.
For most proponents of this view, global imbalances represent an unsustainable phenomenon, whose eventual correction must entail US trade adjustment and a major depreciation of the dollar. For want of a better term, we term this the “disequilibrium approach”.
- The second relies on international asymmetries in the supply and demand for assets – in particular, pent-up demand by international investors for rich-country (and especially US) assets.
For proponents of this approach such as Caballero (2010a and 2010b), global imbalances represent an equilibrium situation that, absent changes in its deep determinants, can be self-sustaining.
The impeccable logic of international financial accounting assures the current-account balance is both a goods phenomenon and an asset phenomenon. After all, if a nation buys more goods and services from the rest of the world that it sells to the rest of the world, there must be an offsetting of assets. The goods-view of global imbalances asserts that it is a goods trade driving asset trade, while the asset-view asserts that the asset trade is a good trade.
The disequilibrium view
Under this view, the persistent US external deficits have been primarily the result of overly expansionary macroeconomic policies as well as financial innovation that encouraged private spending – in particular household consumption and residential investment.
As the US net debtor position vis-à-vis the rest of the world has grown steadily, to 25% of GDP in 2009, the disequilibrium approach implies that the country at some point needs a real adjustment – a turnaround of its trade deficit. This in turn entails a depreciation of the dollar to shift the relative price of US goods versus foreign goods, a change necessary to increase US net exports.
The magnitude of the trade balance correction, and of the depreciation necessary to achieve it, have been the object of detailed analysis in numerous studies – see for example Obstfeld and Rogoff (2005 and 2009), or Claessens et al. (2010).
Yet recent literature has provided a refinement on the size of the necessary adjustment due to the role of financial or balance-sheet adjustment (Gourinchas and Rey 2007). Such a role arises because the change in the net foreign asset position of a country consists of (i) the current-account balance and (ii) changes in the prices of assets and liabilities (financial adjustment).
In the case of the US, financial adjustment, primarily through dollar depreciation, has become increasingly important. Depreciation of the dollar raises the US net asset position because the external liabilities of the US are denominated mostly in dollars, while its assets are denominated in other currencies (usually those of the issuing countries).
This balance-sheet effect has offset a big portion of the current-account deficits in the years preceding the financial crisis (Nguyen 2010). This implies that the real adjustment needed is much more modest once financial adjustment is taken into account.
The equilibrium approach
Under this view, the emphasis shifts to the capital account; there are two main versions.
- The first stresses international asymmetries in the supply and demand for financial assets.
One key ingredient is the financial underdevelopment of emerging countries, which prevents them from generating financial instruments attractive for their savers. Thus, they tilt their portfolios towards assets of countries with more advanced financial markets – the US in particular (see Caballero et al. 2008a, b and Mendoza et al. 2009). Another ingredient is the weak social protection system of many of these countries which forces individuals to save an inordinately large fraction of their income for retirement, or to protect themselves from the risk of unemployment (Carroll and Jeanne 2009).
In the context of international financial integration, this leads to a global equilibrium in which emerging countries acquire a creditor position, whereas advanced countries are net debtors. Without significant improvement in emerging-market financial systems, and/or social protection systems, this “uphill” pattern of capital flows will persist.
- The second version emphasises the deliberate choice of emerging-market policymakers – rather than private savers.
This is dictated by two factors. The first is the so-called “new mercantilist” development strategy – the attempt of a number of emerging markets, particularly in East Asia, to pursue export-led growth. Such an objective calls for an undervalued real exchange rate to preserve export competitiveness. The best way to achieve this is by compressing domestic spending, particularly consumption, which inevitably leads to persistent current-account surpluses and foreign reserve accumulation (see Korinek and Servén 2010 for a theoretical analysis).
The second factor behind the policy of accumulation of external assets is precautionary. In the absence of mechanisms for international diversification of aggregate risk, emerging countries integrated in the global financial system need to resort to self-insurance against external shocks such as disruptions of international capital flows. They accumulate external assets, preferably short-term instruments, from which they can draw in the event of a “sudden stop”. Unless the global financial system generates new international diversification mechanisms, this precautionary foreign asset accumulation is unlikely to stop.
What does the evidence say about these arguments? An analysis of the massive inflows from both private and official sources into the US in recent years seems to lend support to both versions of the equilibrium approach, although official flows – and thus, reserve accumulation – played a larger role after 2007 (Figure 1).
The question remains, however, whether reserve accumulation was driven mainly by precautionary motives, or the pursuit of competitive exchange rates. Aizenman and Lee (2007) show that both motives were at work before 2000 but the precautionary saving motive was more important. Jeanne and Ranciere (2009), in turn, conclude that the accumulation of external assets after 2000 has been too large, particularly in Asia, to be justified by the precaution motive alone.
Figure 1. Gross capital inflows to the US from Asian, Latin American and Middle East emerging markets ($ billions)
Source: US International Transactions, Bureau of Economic Analysis
The future of global imbalances and their implications for developing countries
The global crises witnessed a flight of investors towards the US as a safe haven, and an appreciation of the dollar – instead of the sudden stop of capital flows to the US and the dollar collapse that proponents of the disequilibrium view had anticipated. In light of these facts, which appear to lend support to the asset-based view of global imbalances, the big question is: are global imbalances coming back? It is difficult to give a conclusive answer. The future of global imbalances depends on a constellation of real and financial forces whose evolution is hard to predict. Nevertheless, it may be useful to think in terms of two broad scenarios, and their consequences for developing countries.
The return of global imbalances
Global imbalances may well be restored after the crisis. Several ingredients contribute to make this a likely scenario.
- First, from a global perspective, the crisis has underscored the effectiveness of the self-insurance strategy pursued by emerging markets.
Countries that had amassed big volumes of external assets managed to weather the global storm better than the rest. This success encourages other countries to follow suit.
- Second, in the same vein, barring deep – and, to date, unforeseen – reforms to speed up the development of emerging countries’ financial markets, savers from those countries will very likely continue to demand large volumes of financial assets from more developed markets.
Indeed, Figure 2, which is an update of the graph presented in De la Torre et al. (2009), shows an incipient return of capital flows to their pre-crisis pattern. Although the flows in the figure comprise long- term financial instruments only, the time profile is revealing. The top line captures the inflow of capital to the US from non-resident investors. Up to 2008, it is positive, reflecting an upward trend interrupted in late 2006. The bottom line captures the inflow of capital from resident investors. For the most part, these take on negative values, indicating capital outflows from US investors.
But at the onset of the subprime turmoil in mid 2007, these patterns change abruptly: capital inflows from non-residents collapse, and outflows of residents reverse, reflecting capital repatriation by residents to stem losses in domestic markets or to seek safe haven from the global turbulence. In 2009, however, the data suggests a return to the pre-crisis configuration – capital inflows of foreign investors, and outflows of resident investors, both appear to return to their earlier trends.
Figure 2. US gross capital inflows (in long-term securities) ($ millions)
Source: US Department of the Treasury
Vanishing global imbalances
Though less likely, other forces might push to significantly narrow global imbalances. From an international perspective, the new mechanisms of international risk diversification (such as the contingent credit facility recently established by the IMF) might begin to reduce the incentives for self-insurance and stop the build-up of foreign reserve stocks in emerging economies. However, Jeanne (2010) argues that international risk pooling schemes such as the contingent credit facility are unlikely to have a significant impact on reserve hoarding. An early withdrawal of the fiscal stimuli by the economic authorities in the US and other advanced countries would have similar consequences. Such course of action, however, could also delay the world recovery, and jeopardise the export-led growth strategy pursued by a number of emerging markets.
One way out of this impasse would be for surplus emerging markets to rebalance their economies through an increased reliance on inward-looking growth. In general, an orderly rebalancing of emerging economies with strong external positions and sound macroeconomic frameworks would have to involve an upfront appreciation of the exchange rate (Blanchard and Milesi-Ferreti 2009).
Measures to remove entrenched distortions that cause excessively high saving rates in both the household and corporate sectors, and/or hamper financial development would also help in this regard, although their effects may be only gradual. For example, the strengthening of social safety nets under way in China and other emerging countries is likely to reduce their unusually high household saving rates.
On the corporate side, reforms to speed up the development of bond and equity markets, and strengthen corporate governance, would reduce firms’ incentives to retain earnings and thus bring down corporate saving rates.
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