Imbalances in trade between countries are, of course, as old as trade itself. In the normal course, they tend to get corrected gradually. This phenomenon has however changed considerably in the recent past. Particularly, post the breakdown of the Bretton Woods system in the early 1970s, followed by the globalization, as capital—not backed by trade in merchandise—started flowing around the world financial markets, the global imbalances widened to near unprecedented levels, causing greater consternation to both the surplus and deficit nations.
And in the aftermath of the global economic crisis of 2009, as demand in the world’s major economies fell by around $2.5 tn, high liquidity and continued economic weakness in rich countries led to a surge in capital flows into emerging markets that are strong in macroeconomic fundamentals and are open to free flow of capital seeking better returns.
Aside of this, in today’s system, there has emerged another kind of capital flow: capital from emerging market economies—countries like China and oil-exporting countries which have been enjoying current account surpluses—started flowing into some advanced economies such as the US and the UK that are running large current account deficits, that too, persistently. This ‘uphill’ flow of capital from countries where the marginal product of capital is high to countries where the marginal product of capital is low is puzzling, for it does not anyway raise the global output. Besides, there are also other countries such as Japan and Germany exporting capital to the US: the net external asset position of Japan rose by around $1.7 tn and that of Germany by $0.8 tn, as against the rise in the external liability of the US by $3.5 tn in 2008, almost 25% of its GDP.
Irrespective of the countries involved, such a capital flow supposedly into safe assets has its own consequences: one, it results in a fall in the interest rates in rich countries, which incidentally means low returns to capital exporting countries, at times inflicting high cost on the governments of these countries that intervene in handling the domestic savings for investment abroad; two, a rise in the asset prices of capital receiving countries; three, a surge for financial innovation, perhaps, to secure a better yield; four, a boom in residential construction, as it happened in the US in 2006-08, and ultimately, all culminating in a financial crisis.
So, the emerging reality is: if the global economy has to move towards a steady long-run growth, these imbalances have to be rebalanced. There are, however, opposing views as to how this feat is to be accomplished. Emerging market economies, such as BRIC countries, worry that advanced countries will use exports to reduce their imbalances at the expense of emerging economies’ exports rather than address their structural problems. On the other hand, advanced economies see the exchange rate of major emerging economies, such as that of China, as manipulated to keep it low to nurture their export-led growth model.
But the truth is: in a globalized interdependent world, the pattern of imbalances, as seen above, cannot be ‘blamed’ on any one party. Therefore, the need of the hour is for all parties to take action and work together. It is worth bearing in mind here that any attempt to answer the problem by solely aiming at fixing the US deficit might pull down the aggregate demand from the world economy, leading to the risk of a 1930s-type trade depression. Similarly, any attempt to correct the surpluses solely by expanding the domestic demand in surplus nations risks igniting the global inflation as in the 1970s. In the same vein, it cannot be expected that a mere change in the exchange rate of the US dollar vis-à-vis currencies of surplus countries will solve the problem, for experience shows that exchange rate changes have very limited short-run effects on current account positions. Even other factors such as rigidities in demand elasticities, differences in economies of scale and cost structures across economies might negate the effects of exchange rate changes.
Coming to the emerging economies, they have indeed started moving beyond the traditional export-led growth model. But as many of these countries have relatively underdeveloped financial markets, and low per capita income with poor access to credit, they find it a big challenge to reap the full benefits of the standard macroeconomic policies. So is the case with regard to stimulating the domestic demand, for investment in services is low, and the retail and financial sectors are underdeveloped. Nevertheless, by launching structural reforms, they can unlock the consumer demand, at least in sectors such as education and healthcare.
So, the only way forward for rebalancing the global imbalances is for the creditors (surplus nations) and debtors (deficit nations) to sit together and, as suggested by Mervyn King, discuss about the right speed of adjustment to the real pattern of spending and arrive at a consensus; else, policies will invariably conflict. Simultaneously, policy tools regarding exchange rates, control of capital flows, plans to raise savings rate in deficit countries, structural reforms needed to boost domestic consumption in surplus countries, and the role and governance of international financial institutions must be devised for uniform practice. Unless the problems are dealt with collectively, we might unwittingly pave the way for the next financial crisis.
GRK Murty
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