US Current Account Deficit Financing
In this speech, Rachel Lomax, Deputy Governor responsible for monetary policy, discusses the implications of the global financial imbalances for the current international monetary system. Given their already substantial reserve holdings, Asian central banks are unlikely to continue financing an increasing US current account deficit indefinitely. While the risk of disruptive adjustment may still be low, the sheer scale of current imbalances increases the potential costs of policy mistakes and misperceptions. To minimise this risk, there is a need for clear policy communication and policies that are robust to the possibility of market expectations being inconsistent with economic fundamentals. The increased international interdependency in today’s world also underlies the need to greatly improve the standard of dialogue on international economic issues.Rachel Lomax - Bank of England - Monetary Policy Committee
Global financial imbalances
One spin-off from the debate about global imbalances
has been renewed interest in the international monetary
system. It is a benign aspect of a potentially
acrimonious debate about whether the scale and
persistence of global imbalances — and specifically the
US current account deficit — was made in the United
States or made in Asia — or conceivably Europe (and
maybe even the Middle East).
A better approach is to view global imbalances as the
outcome of decentralised savings-investment decisions
within an interdependent global system. And it’s worth
emphasising straight away that substantial imbalances
may be the natural product of a healthy global monetary
and financial system: they do not necessarily represent a
problem.
But is the current pattern of large and persistent global
imbalances healthy in this sense? Or does it reflect
unsustainable behaviour on the part of policymakers,
companies or private individuals around the world,
rooted in unrealistic expectations, suboptimal economic
policies or tensions between national policy objectives?
Are global imbalances now on such a scale that their
reduction inevitably poses a threat of some kind,
whether to global activity, trade or financial stability?
And does the current international monetary system
embody sufficient incentives to deliver an orderly
correction of imbalances?
At the risk of going over ground which was already
covered yesterday, let me start by briefly reviewing the
changing pattern of global imbalances. In doing so, the
main point I want to make is that this is quite a complex
story, which is consistent with several different — but
not mutually exclusive — interpretations. And, hard as
it is to understand, the past may not be much help in
predicting the future.
The steady increase in the US current account deficit
since the 1990s and its present unprecedented level —
at over 6% GDP — has made it particularly tempting to
look for home-grown factors which can consistently
explain this trend. But the pattern of US saving and
investment underlying its current account deficit look
very different in the pre and post-2000 periods.
The former period was characterised by sustained fiscal
consolidation, leading to fiscal surpluses, together with a
fast growth in private investment in response to high
expected productivity in the United States; the latter
by an emerging fiscal deficit, in response to tax cuts, and
a fall off in business investment. Only the
steady downward trend in the household saving ratio —
now into negative territory — is common to both
periods.
This shift in the composition of the pattern of US
savings and investment has coincided with a change in
the composition of external financing flows into the
United States.
The private equity inflows which dominated in the
earlier period fell sharply after the stock market crash,
and were replaced by inflows into corporate and
especially government bonds.
A significant proportion of the demand for US
government securities came from the official sector,
notably Asian central banks, whose foreign exchange
reserves have more than doubled since 2001.
The fact that the US current account deficit has been
funded at historically low and falling real interest rates
suggests that the fall in US net savings may not have
been the only — or even the main — driver of global
imbalances. And while there are other possible
explanations for the current low levels of global interest
rates, it is certainly true that high saving relative to
investment in East Asia has been an important
counterpart of the US current account deficit. To be
more specific, the rise in saving has outpaced the growth
in investment in China, while domestic investment in
the rest of East Asia remained stagnant after the Asian
crises.
Finally, last year’s doubling of oil prices in response to
buoyant world demand has led to a further change in
the pattern of imbalances, with the combined surpluses
of oil-producing countries now likely to equal half the
US current account deficit, on the same scale as the
combined Asian surplus.
It is, of course, conceivable that these imbalances will
prove to be relatively short-lived. They might be driven
by underlying influences that prove to be largely
temporary — for example an investment overhang in
East Asia, which is eventually worked off, or a purely
cyclical divergence in growth rates between major
regions, or a short-lived spike in world oil prices. But at
the moment there is little sign of this — rather the
reverse.
It is therefore worth reflecting whether today’s
international monetary system (IMS) is sufficiently
robust to ensure that global imbalances can be financed,
contained or corrected through the normal mechanism
of market forces, without crisis; or failing that, whether
institutional arrangements exist to resolve collective
action problems and conflicting priorities without
damage to the wider world economy.
There are three key features of today’s IMS which are
particularly relevant in thinking about this question.
The first is financial globalisation which has totally
transformed the landscape over the past two decades.
Total financial wealth has risen sharply relative to GDP;
and investors are now able and willing to hold a higher
proportion of their portfolios in external assets. The
trend to larger external asset and liabilities has been
particularly significant in industrial countries, whose
external assets and liabilities relative to output roughly
tripled between 1990 and 2003, reaching average levels
of more than 200% of GDP.
This has two effects. First, the expansion in external
balance sheets has relaxed the constraints on the
financing of countries’ savings and investment
imbalances. And second, balance sheet effects can have
material impacts — affecting the link between current
account deficits and external debt burdens, as well as
the external adjustment process itself.
A corollary of financial globalisation has been the
increased importance of market forces, rather than
institutionalised inter-government agreements, in
providing incentives for policymakers within systemically
important countries or regions to follow policies that are
mutually consistent — notwithstanding the longevity of
the Bretton Woods sisters (the IMF and the World Bank).
The second important feature of today’s world is the
rising economic importance of a group of Asian
emerging market economies who heavily manage their
exchange rates. As a result, the international monetary
system has mutated into a ‘hybrid’ system in which some
systemic countries float their exchange rates while
others fix or manage them. One implication is that the
pressure for adjustment to any given shock can be very
asymmetric relative to a floating rate world. Thus,
market driven exchange rate changes are likely to be
concentrated on particular blocs rather than diffused
across the system as a whole. As Obstfeld and Rogoff
and others have pointed out, this is a situation which
could create some difficult policy frictions. These have
the potential to undermine free trade, and weaken world
growth.
The third feature is the continued dominance of the US
dollar as both a reserve currency as well as an anchor for
those countries that choose to fix or manage their
exchange rates. But nowadays countries have choices.
They might fix against the dollar but choose to hold at
least a portion of their reserves in other major
currencies. Since the advent of the euro, the dollar is no
longer the only credible reserve currency.
How do these features of the international monetary
system affect the risks associated with today’s
imbalances?
Financial globalisation has relaxed the constraints on
countries in financing their savings investment
imbalances, thus allowing larger imbalances to be
sustained for longer. This is in principle welcome in so
far as it permits more efficient adjustment over time, and
smoothes the impact of economic shocks on real activity
and consumption. But it also poses major new
challenges for creditors and debtors, both public and
private sector.
The reason is that the price at which the market is
willing to finance imbalances depends on investors’
expectations about the future. This means that debtors
in today’s world face much greater uncertainty about
when credit constraints will begin to tighten. So there is
always a risk that a reassessment of the economic
prospects of a debtor country might lead to a rise in
external financing costs. But there is considerable
uncertainty about whether — and when — such a
reassessment might occur.
This uncertainty is particularly acute in the case of the
United States. Its dominant position in the world
economy, its huge balance sheet and its reserve currency
status make it special in a number of ways.
At present the United States still earns positive net
income from abroad despite a steady deterioration in
the current account since 1991, and a slower rise in its
net external indebtedness. This is not to imply
that the United States is immune to the basic arithmetic
of debt sustainability — sooner or later persistent
deficits will lead to levels of external indebtedness that
represent a significant economic burden even on the
United States; but it is more than usually hard to
predict how long this might take.
The dollar’s central role in the foreign exchange policies
of Asian emerging markets adds to the uncertainty about
the deficit levels at which the United States will face
tighter credit constraints. Since the foreign official
sector — mostly Asian central banks — have been
financing a substantial part of the US current account
deficit (in net terms) and now hold a substantial amount
of the outstanding stock of US Treasuries, private
investors’ willingness to hold dollar assets depends to
some extent on their expectations of what these Asian
central banks will be doing.
Since many Asian EMEs already have far more reserves
than they need for self-insurance against financial crisis,
their appetite for continued accumulation of
US dollar assets will at some stage abate: indeed there
has been some anecdotal evidence of this over the past
year. They can already choose to diversify their reserve
holdings, and the options available may become more
attractive to them with the development of Asian bond
markets.
Their development strategies will also evolve. One-way
intervention has potentially significant costs as well as
benefits — costs which go well beyond the risk of
substantial capital loss in the event of future exchange
rate realignment. These include growing
implementation problems, which are likely to be
particularly acute in very open economies, and a
potentially serious misallocation of domestic resources.
It will not be in the interests of the Asian countries
concerned to ignore these issues.
That is why I find the so-called Bretton Woods II
hypothesis — or at least the proposition that Asian
central banks will have a more or less open-ended
commitment to financing ever increasing US deficits —
rather implausible, at least as a prediction of what is
likely to happen in the medium term, rather than as a
description of the past few years. It assumes the
continuation of unsustainable policies, which are not in
the interests of the countries concerned. I concede
however, that it is hard to make a precise forecast about
the timing of a policy shift in Asia. And it is worth
bearing in mind that this may depend on global and
regional political considerations as much as on
economic and financial pressures.
So given these uncertainties over the evolution of global
imbalances, what should we do about them?
There is clearly no case for turning the clock back and
re-introducing the constraints that characterised the
genuine Bretton Woods system. The challenge is for
policymakers to find ways of operating more effectively
within the current system, to maximise the opportunities
it affords and to manage the risks associated with open
capital markets.
As a monetary policy maker, I am acutely conscious that
a world of large imbalances carries some risk of
disruptive market adjustments, even if the probability of
them occurring is low. These could have a significant
impact on economic activity, especially if they included a
sharp reversion of long-term interest rates to something
closer to their long-run average. We have been trying to
factor this risk in to our thinking about interest rates
as long as I have been on the MPC. But it is not a risk
that maps easily on to any particular interest rate
decision.
While the risk of a disruptive adjustment may still be
low, the sheer scale of current imbalances increases the
potential costs of policy mistakes and misperceptions.
Any disconnect between what the markets expect and
what policymakers intend to do becomes increasingly
hazardous. That puts a premium on excellent policy
communication, to reduce uncertainty and minimise the
risk of sharp market corrections. And policymakers need
to ensure that their policies are robust to the possibility
that market expectations may not be consistent with
economic fundamentals.
Policymakers in systemically important countries also
need to be better at factoring wider political risks into
their decision taking. They need to have an informed
view of how markets and policymakers in other countries
are likely to react, before they decide which domestic
policies are likely to prove sustainable — and they need
to ensure that their policies are robust to possible shifts
in other countries’ policies. The key political risk at
present is of course protectionism — not just the
possibility of bilateral restrictions, but of a fatal lack of
momentum on the Doha round. This could be a
material consideration in almost any scenario created by
financial market pressures.
All these risks underline the need to greatly improve the
standard of dialogue on international economic issues.
The quality of analysis needs to improve, the right
countries need to participate in the debate, discussions
need to be franker, and their outcome needs to be
communicated clearly.
Getting these things right will be tricky but the need for
reform is growing. So I am sure we will need to address
these issues soon. As to how we do it? That’s for
another day.
