Global imbalances pose future challenges

9 November 2009 - The global economy is in recovery mode, but there are concerns about the extent to which global imbalances may compromise future prospects.  We entered the recession, last year, with significant economic imbalances that had grown as a result of excessive, market-distorting, policy measures in a number of countries during the previous boom period.

Inevitably, in response to rapidly deteriorating conditions, policymakers implemented extraordinary fiscal and monetary policies to prevent the eventuality of an even deeper downturn.  Presently, the rebound in the global economy is occurring despite the fact that major disparities have yet to be resolved.

You may recall that, before the recession, export-led policies in China and elsewhere in Asia ran in conjunction with rapid consumption growth in the US, fuelled by easy credit.  This was the notorious vendor-financing model of growth whereby an excessively expansionary monetary policy in the US created a bubble economy and an exceptionally low savings rate, while Chinese manufacturers exported massively to satisfy the American consumption binge.  The resulting surpluses were invested primarily in US-issued IOUs with very low yields.

America’s current account deficit widened dramatically, even as China’s surplus grew substantially.  But it was not just the Asians that were involved in this game.  Many Arab oil producers with currencies pegged to the dollar also ran huge surpluses.

Today, a chastened and concerned US consumer has yet to demonstrate that she is willing to spend more freely, after the sharp pullback during the recession.  The job market is showing few signs of making a quick turnaround and banks are reluctant to loosen up on granting access to credit.  Much of the consumption growth, since the economic rebound, has been the result of generous government programmes, and there is some uncertainty about whether there will be autonomous spending growth after the withdrawal of the stimulative measures.

And the effort to prevent households from a drastic reduction in their spending has produced an enormous fiscal deficit. The deleveraging of the household sector has gone hand-in-hand with substantial leveraging in the public sector.  A higher household savings rate, without incomes plunging precipitously, has been made possible by the rise in government spending and debt levels.  If the government had not spent so freely, the attempt by the private sector to increase its savings rate would have led to a far steeper fall in aggregate income.

Unfortunately, the high fiscal deficit and massive debt will cause big problems in the future, unless markets sense that a viable process will come into play to reduce them.  For this to be achieved there has to be a combination of a rise in spending, led principally by consumers, and an increase in net exports.

To base growth on a substantial rise in household spending, without much improvement on the export front is likely to require another spate of leveraging by the private sector.  In addition, a gaping current account deficit may put further downward pressure on the dollar and upward momentum on interest rates, compromising the recovery.

In China, the huge stimulative package, initiated by the government last year, has done a great job in maintaining growth at a high level.  But the issue of imbalances hasn’t been addressed fundamentally.  Too much of the effort has gone into capital expenditures and too little attention directed at shoring up household consumption. And the export sector is still quite important for the Chinese economy if policymakers’ objective of maintaining a consistently high growth rate is to be met.  Also, in terms of domestic demand, there are concerns that the large stimulative programmes are causing excesses in certain sectors that need to be addressed before they cause bubble trouble.

So the wellbeing of American consumers, as well as those in other countries, must still enter into policymakers’ calculations.  Meanwhile, the financing of America’s external deficit continues, even as there are worries about the future value of China’s huge holdings of US government securities.

At the same time, Chinese officials are reluctant to allow the revaluation of the renminbi, which the Americans see as substantially undervalued against the dollar.  But the authorities in China are in no hurry to make adjustments.  They want much more time to restructure their economy and institute a sophisticated financial system before allowing their currency to float.

Currently, trade disputes are on the rise, with US authorities taking the lead in imposing sanctions and tariffs on a number of imports from China.  And, of course, the Chinese have responded with a set of retaliatory measures.  Unfortunately, other countries are also falling into the trap of greater protectionism.  This is hardly a hopeful sign, as the global recovery is still less than fully robust.  

For lack of space we have focussed principally on the important US-China economic relationship in discussing global imbalances.  Other countries and regions are also involved in finding a solution to the discrepancies.  But it is clear that policy compromises and economic adjustments will be difficult to make and this increases the risk of non-optimal outcomes in the future.