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The Sources of Global External Imbalances

Yan Wang's picture

Although the world economy has been growing at a decent rate in the last three years, the global current account imbalances have reached unprecedented levels.  On one hand, the US current account deficit rose from $665 billion in 2004, to $820 billion or 6 percent of GDP in 2005, and is expected to reach $900 billion in 2006. On the other hand, there is a rapid accumulation of foreign exchange reserves in Emerging Asia as well as in oil exporting countries.  As global current account imbalances have grown, the dispersion in net foreign asset positions has also correspondingly increased.  The US net foreign asset position steadily deteriorated between 1996 and 2002, while Japan, emerging Asia and oil exporters have built up significant creditor positions.

Economists have vastly diverse views on the causes and implications of the global external imbalances as well as their proposed policy responses.  This note provides a survey of recent literature and summarizes those views.

Three Different Views on the Causes of the Global Imbalances

  1. The optimistic view is that we have entered a new golden age where the current international monetary and financial system is the Bretton Woods system reborn.  Today, like 40 years ago, the international system is composed of a core, which has the privilege of issuing the currency used as international reserves, and a periphery, which is committed to export-led growth based on the maintenance of an undervalued exchange rate (emerging Asia and in particular China). Defying all economic theories, the large current account deficit in the US has not let to a depreciation of the dollar, as 50 percent of this deficit has been financed by foreign central banks and another 50 percent by private investors.  As a result, US interest rate has been kept low, and consumer spending has been resilient and corporate profitability has been strong even in the face of a roaring oil price, escalating budget deficit and the detrimental impact of Katrina. Some argued there is an overly optimistic expectation about future investment returns in the US based on the high productivity growth in the 1990s. Thus, a large amount of oil revenue has been recycled back to the US which is one of the reasons that the US dollar remains strong.  According to this view, there is no real reason for concerns as long as foreign central banks and investors are willing to hold dollar and finance the US Current Account deficits.  In this view, the current international settlement system can be maintained indefinitely, and there is little need for policy adjustment.

  2. The second group considers the global imbalances as mainly due to a “global saving glut” where the swing in the saving-investment gap from deficit to a large surplus in emerging Asia has resulted in an excess global supply of saving (a global saving “glut”) that has been channeled to the US to finance its large current account imbalances (Bernanke 2005, also Chapter II, IMF’s WEO). This would also explain the low level of long-term interest rate in the face of a low and declining rate of savings in the US and other industrial countries. According to this view, consumers in emerging Asia seem to have saved too much as compared to investment opportunities in their own economies. Several structural and policy issues in China have kept savings rate high and investment returns low including, e.g. inadequate provision of health and social insurance, and an inefficient banking system. A variant of this group focuses only on the exchange rate regime in China and emerging Asia as the main source of imbalances. According to this view, it is China and the rest of emerging Asia who need to adjust/reform their policies. Others, however, have argued that the US is the biggest beneficiary of high savings rate in China and other Asian countries, and that US economy has been riding on the high savings rates in these countries (Fehr, Jokisch, and Kotlikoff 2005). Using the overlapping generations model they predict that in the long term interest rates will continue to be kept low and the real wage rates will rise, rather than fall, thanks to the high savings rate in China. “China eventually becomes the world’s saver and the developed world’s savoir with respect to its long term supply of capital and its long-run general equilibrium prospects.” (Fehr, Jokisch, and Kotlikoff 2005, p.1). 

  3. The third group has argued that the sharp drop in the national saving in the US --reflecting the deterioration in the fiscal position and the increase in housing wealth-- and the recent rebound in investment are at the root of current account imbalances (see, for example, Roubini and Setser 2005). Indeed, the CA deficit was widened by 2 percentage points, and fiscal deficit worsened by 6 percentage points, but dollar remained strong in 2005. The increase in saving in China and other Asian economies has contributed to keeping the interest rate low. But this “ideal” world of Bretton Woods 2 system will not last long. Roubini argues that it will unravel “in less than 5 years”. Sooner or later, the willingness of central banks and private investors of holding dollar denominate asset will decline. And many worry that Bretton Woods 2 will unravel in a disorderly fashion, resulting in a hard landing. Why? “Because the global imbalances have been worsening and currently no one is doing anything about it. The US is not doing much on its twin deficits and China is not likely to budge on exchange rate appreciation.” Therefore, Roubini argues that the probability of a hard landing is rising.

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