FT: Exchange rate disequilibrium

An equilibrium that cannot be sustained
DEALING WITH GLOBAL IMBALANCES: Exchange rate movements remain small
compared with what is likely to be required to achieve a better
balance, writes Krishna Guha
Financial Times (London); Sep 13, 2006; KRISHNA GUHA; p. 3
The outlook for global economic imbalances has unquestionably improved
this year with the slowdown in the US and stronger growth in Japan and
the eurozone. In dollar terms, the roughly Dollars 850bn a year US
current account deficit seems to be levelling out and may edge
downwards as the US slowdown takes hold.
There have been glimpses, too, of a greater shared understanding of the
problem by national economic policymakers, and a new role for the
International Monetary Fund. But further increases in the price of oil
have pushed in the other direction, adding to existing imbalances while
also undermining growth and putting upward pressure on inflation.
With the six countries of the Saudi Arabia-led Gulf Cooperation Council
alone forecast to run a current account surplus of Dollars 227bn this
year, up from Dollars 87bn in 2004 and Dollars 167bn in 2005, according
to the Institute of International Finance, the oil exporters are now a
central part of the imbalance equation.
It is doubtful that US consumption growth will slow dramatically enough
to produce sizeable declines in imbalances without big changes in
exchange rates and exchange rate movements remain small compared with
what is likely to be required to facilitate a substantial shift towards
greater balance, with China and other Asian nations resisting currency
appreciation. Nonetheless, the rebalancing of growth among
industrialised countries clearly helps.
"With a rotation in global growth, one of the ingredients for
rebalancing is slowly coming into place," says Raghuram Rajan, chief
economist at the International Monetary Fund.
As Japan and the eurozone grow faster, their consumers will spend more,
including on imports, while the surplus of savings over investment in
these economies should diminish. The debate is over how much more
balanced global growth will help.
Some argue that, with US trend growth even at 3 per cent far higher
than trend growth in the eurozone or Japan, and US consumers
historically displaying a higher marginal propensity to import, the
impact is likely to be small. Others think the difference in
consumption growth over the years ahead could be large, producing a
significant effect on imbalances.
"We are approaching a turning point in the global economy," says Ken
Rogoff, a professor of economics at Harvard. He says US consumption
growth is likely to grow very slowly for several years to come, as the
housing boom subsides and the household savings rate moves back towards
more normal levels. A sharp slowdown in US consumption, particularly if
it were accompanied by a slowdown in China, would bring oil prices and
surpluses down too.
There is a near consensus, though, that to reduce imbalances
substantially without a global recession there will have to be changes
in relative prices of imports and exports, traded and non- traded
goods, via exchange rates.
Martin Feldstein, another professor of economics at Harvard, says
"there is general agreement that the US current account deficit must
decline substantially, that an acceptable slowdown in US growth will
not be enough to achieve that adjustment, and therefore that a big
currency realignment will be necessary.
Research suggests that changes in exchange rates in isolation will not
have a great effect on imbalances, but that they are required as part
of a broader shift to bring the world economy back to balance.
Last year Mr Rogoff and Maurice Obsfeld, a professor of economics at
the University of California, estimated that the dollar will have to
fall by 33 per cent in real terms if the US trade deficit is to
disappear altogether, or by 17 per cent if it is to be cut in half.
These estimates remain roughly the same today. But as the two point
out, the required dollar depreciation could be much greater if it took
place over a short period.
Moreover, the distribution of the burden of adjustment depends hugely
on whether Asia, including China, shares the required offsetting
appreciation with Europe. So far this year there has been little
movement in the renminbi, though there is some hope of more rapid
appreciation to come.
Further structural reform, too, is essential to bring imbalances down.
Usually, the finger is pointed at the sluggish eurozone or Japan.
But while structural reform in these economies is desireable for its
own sake, it is likely to have only a modest effect on imbalances, and
only if productivity rises fastest in the non- tradeable goods sector.
The bigger prize may be in emerging markets in Asia, where a
state-funded safety net and financial sector reform could facilitate a
fall in the savings rate.
For now, international pressure is focused on Asia and in particular
China, to allow currency appreciation and rebalance economic growth
away from exports. Oil producers are certain to come under increasing
scrutiny, particularly if oil remains near recent record highs.
However, there is a natural rebalancing mechanism via higher public
spending in these countries.
Of course, the longer the imbalances persist, the more tempting it is
to view them as sustainable. Some analysts argue that the US is
performing the role of a global financial intermediary, producing
assets that cannot be found in developing economies. In another version
of this story, the US captures a return premium from selling debt and
buying equity, to which it adds value, abroad.
However, financial reform will over time improve the availability of
financial assets outside the US and returns on equity investments
overseas are likely to be more volatile than fixed income returns.
While the US was growing far more rapidly than the rest of the
developed world, and offered an interest rate premium, investors may
have regarded the risk of currency losses as minimal. But as global
demand rebalances, it seems inevitable that at some stage they will
demand higher rates of return to offset exchange rate and concentration
risk. Many important decisions will be made by central banks operating
de facto dollar pegs, and they cannot easily diversify out of dollars.
Moreover, the moderate level of interest rates worldwide suggests there
is still a surplus of desired savings over investment. So substantial
imbalances may remain the equilibrium outcome for some time. But this
equilibrium is not ultimately sustainable.
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