How will global external imbalances adjust? Economists have vastly diverse views. The IMF presented two adjustment scenarios using its Global Economic Model, a benign baseline and a more abrupt adjustment. Depending on views regarding the probabilities of various adjustment scenarios, proposed policy responses differ. This note provides a survey of recent literature and summarizes diverse views on various assessment of the probability of a hard landing, and the proposed policy responses.
The benign adjustment scenario presented by the IMF requires a gradual reduction of current account surplus in emerging Asia, and a gradual rise in real interest rates in the US leading to an increase in savings rate, a slowdown in GDP growth and a reduction in the CA deficit to 3.5 percent of GDP by 2010. However, this scenario depends critically on the willingness of foreigners to accommodate a further buildup in US foreign liabilities without demanding a large risk premium. (IMF, 2005, WEO)
The second scenario looks at the impact of a more abrupt and disorderly adjustment –a hard landing. Assuming a combination of a rise in protectionism and a sudden decline in demand for US assets including an abandonment of pegs in emerging Asia, this will lead to a sharp contraction in the US economy. The sudden shift in portfolio preference away from US assets forces a large real depreciation of the dollar, and a sharp correction of the trade balance. Together with the rise in protectionism, this leads to rising inflationary pressure, requiring a significant monetary tightening in the short term, which amplifies the contraction in GDP growth. The emerging Asia experiences a sharp real appreciation, a deterioration in trade and current account balances and a slowdown in growth. Similar impact will be felt in Japan, euro area countries, and other developing regions. The hard landing will lead to a global slowdown with severe consequences to the poor.
Professor Roubini, among others, argued that the probability of a hard landing has increased for the following reasons.
First, there is a great deal of complacency in the US, and it is quite apparent that the government is not doing anything to resume its fiscal discipline by cutting spending or increasing taxes. About 100 percent of US fiscal deficit has been financed abroad.
Second, China may be forced to allow more exchange rate flexibility and adjust its portfolio allocation due to economic reasons. China’s economy is becoming increasingly imbalanced –with a large CA surplus and partially sterilized capital flows, there has been a rising money supply and abundant liquidity which feeds into a lending boom. With limited investment opportunities, this leads to overinvestment and declining returns from investment which exacerbate the NPL problems of the banking system. The asset /real estate bubbles and regional and sectoral imbalances may force the government to abandon the tightly managed exchange rate and allow the currency to appreciate. Recently, the State Administration of Foreign Exchange (SAFE) has indicated their intension of diversifying its asset holding.
Third, if China does not adjust its exchange rate, the rest of emerging Asia is not likely to do anything for the fear of losing competitiveness. However, in his view, if China adjusts its exchange rate and asset holding, the rest of emerging Asia may follow suit. If a group of central banks takes similar actions, this may in turn lead to a sudden change in the investor sentiment, resulting in a sharp contraction in the global economy and a greater risk of financial market disruption.
Jury is still out as to which of these different views and scenarios turns out to be correct. However, the severity of the current global imbalances calls for concerted actions by all, including:
- A rapid fiscal consolidation to raise savings rate in the US;
- Greater exchange rate flexibility in Emerging Asia; and
- Structural reforms in Japan and the Euro area to boost growth and domestic demand through increasing labor market flexibility and competition.
This note provides a non-technical background briefing to policymakers and practitioners in developing countries. In particular, this will be useful as background for our Global Seminar on Capital Flows and Global External Imbalances, to be held in Paris, April 3-6, 2006.
- Macroeconomic Management