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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