global imbalances project updated

8/7/2019 Global Imbalances Project Updated

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DT366/3 Group Project: Group4

Global Imbalances: A Critical Study of the

Possible Causes and the Probable Solutions

Raza G. Mujtaba, Jasmine Chieng, Marianna Falchi, Michael Moylan, Patrick Redmond.


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Introduction

This essay considers the origins of global current account imbalances. There is a wide range ofliterature on the topic of global imbalances but this essay will only cover some of the topics thatare considered to be the most relevant. We first discusses the role of emerging east Asianeconomies which have been running huge current account surpluses for a long time then wediscuss how the expansion of the US current account deficit and the decrease in global realinterest rates can be reconciled with the widespread view that American expansionary fiscalpolicy is partly the source of current trends. The US monetary policy during the early 2000s willalso be discussed along with the role of the financial institutions in these crises in terms ofsecuritization. At the end this essay will also shed light on the possible solutions which may helptame this difference in the patterns of savings in both the developing and the developedeconomies.

The Role of Emerging Asia

Several commentators have argued that the large current account surpluses in developing East

Asian economies and in the recent past in the oil exporting economies (due to the record oilprices between 2004 and 2007) are at the heart of the pattern of the global imbalances. If thisview is to be taken than these surpluses had to be offset somewhere and that somewhere, it iswidely believed, was the US largely because of the attractiveness of the American assets particularly after the Asian crisis in late 1990s. Dooley et al. (2007) state the US currentaccount deficit is the outcome of the concerted mercantilist effort by the East Asian state actors.In this context, the financing of Americas trade (and Budget) deficit is and explicit quid pro quofor the continued access to American markets.

It does seem illogical to blame solely the savings pattern in the emerging Asian markets for thecurrent global imbalances, the US fiscal policy has to share the blame as well particularly whenthe US economy is three times the combined economies of the developing Asia, argue Chin andIto (2008).

The discussion above does beg a question, why did most of the surplus savings ended up in theUS and not in any other industrialized economy? Gruber and Kramin (2009) argue that it was thehigh level of the financial development in the US relative to its industrial peers which might beable to explain this phenomenon however when this hypothesis was put to test Gruber andKamin (2009) did not find any significant relationship between the current account deficits andthe level of investments in an economy.

Low real World interest rates

Chin and Ito (2008) argue that after the Asian crisis in late 1990s and the recession in the US inearly 2000s triggered the responsive policy changes in both the US and the East Asianeconomies that resulted in the US real interest rate to be higher than the world real interest ratewhich should explain the funds flowing from rest of the world to the US as shown in thediagrams below.


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Both the US economy and the group of the East Asian economies are large open economieshence the loan-able funds market (LFM) sets the interest rate for the economy. In the USeconomy the interest rate is initially set at Ro and as a response to the recession in the early

2000s the Federal Reserve decided to pursue the expansionary fiscal policy which caused thetotal savings (S) to shrink, the new S curve becomes S1. From the above diagram the USeconomys fiscal policy must have brought the interest rate at R1 if the market were to workfreely, however as a result of the US monetary policy the interest rates are kept low at R*. TheUS could afford to do this because the dollar is the reserve currency of the world which makes itattractive for developing economies which want to mitigate any currency exchange rate risk andoil being traded in dollar which makes the investment in the US assets more attractive for oilexporting economies. At R* it can be observed that the demand for Investment funds in the LFMis higher than the Savings in the US and this gap was financed through the savings flowing infrom the east Asian economies argues Bernanke, B (2005). In the East Asian economies afterthe Asian crisis the investment opportunities shrunk which is indicated by the Investment

(I+NCO) curve shifting inwards from (I+NCO)0 to (I+NCO)1 in the Diagram and the surplussavings resulting in the S curve shifting to the right in the East Asian economies. Chin and Ito(2008) assume that even though these two economies are big enough to influence the worldinterest rate, the confluence of the changes in the two economies clear off any significant impacton the world interest rate hence the world interest is believed not to have changed much as aresult of the above changes. Therefore, it can be seen from the diagrams above that as the USinterest rate after the fiscal expansion offers a higher yield in the LFM which results in thenegative Net Capital Outflow (NCO) which explains the current account deficits in the US.

The Savings Glut Hypothesis

A particularly famous theory presented by Governor Bernanke in his 2005 speech in Richmond,Virginia was the Savings Glut Hypothesis. This was one of many theories which helped toexplain the size of the global imbalances. One of the major consequences of the savings glut hasbeen the deficit in relation to the current account balances. Bernanke argues that Over the pastdecade a combination of diverse forces has created a significant increase in the global supply ofsaving--a global saving glut--which helps to explain both the increase in the U.S. current accountdeficit and the relatively low level of long-term real interest rates in the world today. The


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The current account surpluses of oil exporters, notably in the Middle East but also in countriessuch as Russia, Nigeria, and Venezuela, have risen as oil revenues have surged. [] thecollective current account surplus of the Middle East and Africa rose more than $40 billion between 1996 and 2003; it continued to swell in 2004 as oil prices increased yetfurther(Bernanke, 2005). The rise in oil prices most definitely was a main cause of the savings

glut as it increased the current accounts of the oil rich countries.

Oil Price History and Analysis(James L. Williams, 2007)

Another important cause which has lead to this savings glut is the aging populations of countrieslike Germany and Japan. The workers in these countries save a large proportion of their incomesfor an uncertain future. The populations of most of these countries are both growing slowly andaging rapidly, implying that ratios of retirees to workers will rise sharply in coming decades. Forexample, in the United States, for every 100 people between the ages of 20 and 64, there arecurrently about 21 people aged 65 or older. According to United Nations projections, by 2030the population of the United States will include about 34 people aged 65 or over for each 100people in the 20-64 age range; for the Euro area and Japan, the analogous numbers in 2030 willbe 46 and 57, respectively.

History ofCurrent Account Deficits

Over the past decade there has been a sharp rise in global imbalances with primarily developed

countries running current account deficits while developing economies were running currentaccount surpluses. It is supposed that this was primarily due to low savings to GDP ratios in theUnited States and increasing savings to GDP ratios in China and the Middle East. The currentaccount deficit of the US rose steadily from 1997 onwards and reached a peak of around $800billion or around six per cent of GDP. As a result of this the aggregate current account balancesfor developed economies followed a similar pattern, even though countries such as Germany andJapan were running current account surpluses. This occurred while the developing world, China


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and the Middle East, were experiencing increasing current account surpluses causing a greatershift in the global imbalance.

The current account deficit in the US came about as a result of low and decreasing savings balances. The current account is effectively savings less investment and with a consistentdecrease in savings in the US and steady levels of investment there was a sharp increase in thedeficit from 1997 to 2007. In contrast the developing economies of China and oil producingcountries were experiencing large increases in current account surpluses due to their positivesavings to investment ratios. This caused a massive inflow of capital into the United States fromthese countries due to an appreciation of the dollar, rising house prices and the status of thedollar as the world reserve currency. The current account deficit in the US was exacerbated by alow real interest rate which discouraged saving and boosted consumption and inflows of capitalfrom developing countries S < I = NCO

The reason for growing current account surpluses in emerging Asian economies can be linked tothe Asian Financial Crisis of 1997. Following this, investment fell due to a collapse in assetprices causing the savings to investment ratio to rise and thus creating a large surplus. There wasa large accumulation of foreign currencies in order to restore reserves also the lack of socialsafety nets caused the personal savings to increase. This increase in savings and fall ininvestment lead to an overall increase in current account surpluses causing exports to rise andcapital to flow out.

S > I = NCO +


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How to correct the Global Imbalances

Sibert, A (2009) considers the role of monetary and fiscal policy to be vital in correcting thecurrent imbalances and also for avoiding the future crisis. An obvious fiscal policy that the USmight take is to eliminate incentives for the home ownership (which it has long promoted andwhich ultimately led to the residential investment in the US being too high and saving too low).Also the present US administration should eliminate the Bush era tax cuts which mosteconomists believe are too lenient. On the other hand East Asian economies particularly Chinahas to absorb some of the excess savings domestically. Although the current account imbalanceshave started to look like contracting this contraction is believed by most economists astemporary. Baldwin and Taglioni (2009) believe,

The rapid collapse of trade between the third quarter of 2008 and the first quarter of 2009improved most balances of trade. It could not have done otherwise; if both imports andexports drop rapidly, the gap between them drops equally rapidly. In the samemechanistic manner, the recovery of trade flows a recovery that seems to have startedthis summer will almost surely return the US, Germany, China and others to their oldpaths.

We are living in a situation where the capital is flowing from poor to rich countries to finance thebudget deficits of the relative developed economies (this is, to an extent, related to the inflexibleexchange rate for example Yuan being pegged to the US dollar (which gives China an unfairadvantage over the US). However the current pattern could be solved by changing deficitcountries attitude to excessive consumption and inadequate savings. At the same time Investmentneed to be stimulated by financial and product market reforms to encourage companies to invest.Restrictive regulations in product market are in fact not desirable since they shield domesticfirms from foreign competition consequently discouraging the investment.

Cooperation between developed and developing countries is necessary to solve the situation.A step forward is surely G20 summit. It was created as a response to the financial crisis and has

taken place three times. The last one, in Pittsburgh, produced a pledge to expand developingcountries influence. In fact, self-insurance is also the motive of the rapid and excessive growth offoreign exchange reserves in the last years. In effect high reserves are supposed to insulate acountry from capital outflows and crises. When these are excessive this lead to imbalances,hence reforms are needed in the international monetary system so that countries would not needto build a cushion of foreign exchange reserves. A goal would be the reform of the IMF and itsfacilities in order to remove the stigma perception about IMF involvement.

Another reform would be about the bilateral FX swaps, since several countries, especially theemerging countries which have been excluded from this kind of support, wish for it. The mostpromising avenue is the one which aim to the designing of a new system for temporary liquidity

support for prudent countries. One way could be an FX Liquidity insurance Mechanism thatwould help prudent countries with domestic financial institutions, temporary credit and guaranteeschemes. The operators of FLI would be the IMF, central banks and governments. The IMF ismoreover open to supporting regional arrangements. Measures against exchange ratemisalignments are suitable too. These need to be limited, and the way to accomplish that ismultilateral surveillance combined with an institutional mechanism aimed at avoid exchange ratemisalignments and the implementation of policies to deliberate exchange rate undervaluation.


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References:

Baldwin, Richard and Daria Taglioni, The Illusion of Improving Global Imbalances,VoxEU.org, 14 November 2009

Bernanke, Ben S (2005), The Global Saving Glut and the U.S. Current Account, remarks at the SandridgeLecture, Virginia Association of Economics, Richmond, VA, 10 March (2005).

Bernanke, Ben S (2010), Monetary Policy and the Housing Bubble,remarksat the Annual Meeting OfThe American Economic Association, Atlanta, Georgia, January 3, 2010.

Browne, Paul. and Newman, Jane. (2008) Securitisation In The Peoples Republic Of China:Moving Forward, But Challenges Still Remain, Global Securitisation and Structured Finance:120-126

Bruegel, Zsolt D (2010) Future development of global imbalances, Policy Department A:Economic and Scientific Policies, European Parliaments Committee on Economic and Monetary Affairsworking paper,March 15, 2010.

Chinn, Menzie D. and Hiro Ito (2007), Current Account Balances, Financial Development, andInstitutions: Assaying the World Savings Glut,Journal of International Money and Finance 26:54669.

Dooley, M., D. Folkerts-Landau, and P. Garber (2003), An Essay on the Revived Bretton WoodsSystem, NBER working paper 9971., Direct Investment, Rising Real Wages and the Absorption of Excess Labor in thePeriphery, in R. Clarida (ed.), G-7 Current Account Imbalances: Sustainability and Adjustment,Chicago: Chicago University Press (2007).

Gruber, Joseph W. and Steven B. Kamin, (2008). Explaining the Global Pattern of CurrentAccountImbalances,Journal of International Money and Finance 26:50022.

, Do Differences in Financial Development Explain the Global Pattern of CurrentAccount Balances? International Finance discussion paper 923.

James L. Williams, 2007, Oil Price History and Analysis, viewed 17:32, 18/11/10,

Sibert, Anne (2010), Global imbalances and the financial crisis, Policy Department A: Economic andScientific Policies working paper,March 8, 2010.

Whelan, Karl (2010) Global Imbalances and the Financial Crisis, Policy Department A:

Economic and Scientific Policies, European Parliaments Committee on Economic and Monetary Affairsworking paper,March 8, 2010.

Xafa, Miranda (2007),Global imbalances and financial crisis, Journal of Policy Modeling29: 783796


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Declaration:

I declare that the work above is my own has not been plagiarized.

global imbalances project updated

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