Waiting for the great rebalancing

By Martin Wolf

Published: April 5 2011 21:19 | Last updated: April 5 2011 21:19

Pressures are building up for a rebalancing of the world economy. The private sector has long
been trying to send a large net flow of capital from the world’s relatively sluggish rich countries
to its dynamic emerging ones. But the governments of the latter have resisted, by intervening in
currency markets and sending the capital back as official currency reserves. But forces now at
work in the world economy seem likely to bring this recycling to a natural end. If so, that would
be very helpful, though it would also create new challenges.

Mervyn King, governor of the Bank of England, has given an account of the role of the so-called
global imbalances in February’s Financial Stability Review of the Banque de France. This
“uphill” flow of capital from poor to rich countries, predominantly into supposedly safe assets,
had important consequences: a reduction in the real rate of interest; a rise in asset prices,
particularly of housing in several countries, not least the US; a reach for yield; a wave of
financial innovation, to create higher yielding, but supposedly safe assets; a boom in residential
construction; and ultimately a huge financial crisis. The follies of finance and failures of
regulation bear the blame. But global developments – not just the so-called “savings glut, but the
form that those flows took – helped create the conditions for the disaster. Indeed, a clear
correlation exists between the rise in non-performing loans during the crisis and countries’ initial
current account positions.

As Mr King also notes, the underlying determinant was a surge in savings in already surplus
regions even greater than their rise in investment. In another recent paper, for Morgan Stanley,
entitled The Great Rebalancing, Alan Taylor of the University of California at Davis and Manoj
Pradhan, show the same thing, this time for emerging countries specifically (see chart).

Why then did the surge in savings take place? Mr King suggests three explanations: a shift
towards export-promotion, which created the need for highly competitive real exchange rates; a
decision to accumulate foreign currency reserves, in the aftermath of the financial crises of the
1990s; and the combination of low levels of financial development with inadequate social safety
nets, which encouraged higher savings. In China, one would also have to add the surge in
corporate profits. The outcome, then, was partly the result of deliberate policy – particularly in
the case of the form that the capital outflow took – and partly the result of spontaneous
developments.

Whatever the role of the uphill

capital flows in causing the crisis, on which controversy reigns, it is agreed that full recovery
demands a rebalancing. In the post-crisis world, hitherto buoyant household spending in the US
and other affected countries, is likely to be weak, as deleveraging proceeds. Non-financial
corporates have been running financial surpluses (an excess of retained earnings over
investment) for a long time. This has now left governments with huge deficits. If the latter are to
be reduced, while sustaining recovery, massive shifts in the external balance are needed.

Might this now happen? The Morgan Stanley paper argues that the answer is: yes, for four
reasons.

First, foreign currency reserves proved their worth during the crisis, which left emerging
economies surprisingly unaffected. But the crisis also showed that existing reserves are more
than large enough. The reduction in foreign currency reserves between September 2008 and
February 2009 was $428bn, just under 6 per cent of the global total. In aggregate, reserve holders
proved more than adequately insured even against the biggest crisis since the 1930s. Moreover,
the cost of holding reserves in an era of ultra-low interest rates in the countries whose currencies
are used for this purpose is also high. In China, the cost may now be 1.5 per cent of gross
domestic product. Furthermore, export-led growth also looks much less attractive in an era of
consumer retrenchment in the rich countries.

Second, a pent-up demand exists for higher investment, in both advanced and emerging
countries. China is a large exception, with its already extraordinary investment rate. But India’s
investment rate may explode upwards, above all in infrastructure. The rising share of emerging
countries in world output will also itself raise the global investment rate substantially.

Third, consumption is likely to soar in emerging countries. This is now a specific objective of the
Chinese government, which has realised the dangers of relying on demand from high-income
countries.

Finally, in the short run, private savings are likely to rise in advanced countries. But, in the
longer run, ageing will reduce them, though not enough to halt rebalancing.

The Morgan Stanley paper concludes that the impact of these changes will include higher real
interest rates, global rebalancing and higher real exchange rates in emerging countries. The latter
can occur through higher nominal exchange rates or higher inflation. Many emerging economies
are now reaching their maximum tolerance of inflation. This suggests that faster appreciation is
likely to be a bigger part of the policy mix, not least in China. For the Chinese government, high
inflation is a disaster, far more so than any modest loss in external competitiveness. If China
were to let the renminbi appreciate faster, others are also likely to follow.

On balance, the shifts described look plausible. But they are likely to bring substantial pain.
Higher real interest rates would increase the difficulties of the overindebted, be they private
people or governments. Furthermore, emerging countries will resist the envisaged shift: global
reserves rose by a further $2,192bn between February 2009 and December 2010. This rate of
accumulation is surely destabilising. But it is ongoing. I will not forecast when it might end. I
can say that nine trillion dollars is surely enough.

The debate over the future of the global monetary system is ongoing. But, quite pragmatically,
the emerging countries modify it on their own. They decided to protect themselves against the
vagaries of global finance by accumulating vast claims on the issuers of reserve currencies. That
episode must surely come to an end, particularly now that inflation is becoming a greater fear.
Moreover, structural forces are also likely to generate the needed “great rebalancing”. But the
road to adjustment has only just begun. Watch out: it is likely to be bumpy.