Global Imbalances What Global Imbalances? Willem H. Buiter Professor of European Political Economy, London School of Economics and Political Science (New & one hopes improved version) Presentation prepared to introduce a debate on ‘Global Imbalances’, on the occasion of the award of the Premio "German Bernacer de Economia Monetaria to Professor Hélène Rey, on May 21, 2007 at the Banco de España. © Willem H. Buiter 2007 • There is a tendency in the economics profession to regard anything that is not indefinitely sustainable - not in steady state - as an ‘imbalance’. Following this usage, the following would represent imbalances: –Any positive population growth rate –My life –Life on earth 2 Laws of Unsustainability 1. 2. 3. 4. Herbert Stein’s Law: "If something cannot go on forever, it will stop". Rudi Dornbusch’s First Corollary of Stein’s Law: “Something that can’t go on forever, can go on much longer than you think it will”. Rudi Dornbusch’s Second Corollary of Stein’s Law: “The speed and magnitude of the eventual turn around will always take you by surprise”. Ben Friedman’s Perverse Corollary of Stein’s Law: “…in the presence of large ……. deficits nothing need be done because something will be done.” 3 • Preferred definition of ‘imbalance’: a process that: – Is unsustainable – Is unlikely to be corrected spontaneously without painful adjustment – requires policy/institutional changes for orderly/least cost correction 4 The US current account deficit • The US NIIP (net international investment position) is (likely to be) a significantly larger negative number than the official BEA data (20.4% in 2005) suggest. • True US net foreign factor income is (likely to be) a much larger negative number (maybe 1.5% to 2.0 % of GDP) than the official nearzero figure. • A belief in ‘dark matter’ indicates the likely absence of ‘grey matter’. • Therefore the US current account position is ‘unsustainable’. • Despite being ‘unsustainable’, the US current account deficit is not a problem. 6 Why do foreigners invest in the US? • Cumulative current account deficits of US 1980-2004 are $1.7tn larger than the fall in US NIIP. • 2004, US net external liabilities = $2.5tn & US net foreign factor income = $30bn: a rate of return of effectively zero • Who are these shockingly inefficient foreign investors in the US? 1. Central banks acting as ‘reverse hedge funds’ • • People’s Bank of China: $1.2 tn in 2007, QII, mostly in TBs, much of it in US TBs Bank of Japan: Around $1.0tn in 2007, much of it in US $s 7 Rank Central Bank/Monetary Authority billion USD (end of month) 1 People's Republic of China $1202 (March) 2 Japan $916 (April) Eurozone $451 (March) 3 Russia $386 (May 11) 4 Republic of China (Taiwan) $267 (April) 5 South Korea (Republic of Korea) $247 (April) 6 India $204 (May 04) 7 Singapore $140 (April) 8 Hong Kong, China $137 (April) 9 Brazil $122 (May 02) 10 Germany $115 (March) - Source: Wikipedia 9 2. Foreigners holding US currency: seigniorage earned on the stock of US currency held abroad (Allison (1998), Doyle (2000), Rogoff (1998) Drehman et al. (2002)). Between 30% and 75% US currency held abroad (BEA estimate for end of 2004: $333bn; own estimates (Buiter (2006)), between $200bn and $500bn. 10 Dark Matter or Cold Fusion? • Evidence that rate of return on US external assets is systematically higher than on US external liabilities is either non-existent or unconvincing – Gourinchas and Rey (2006a,b): over past three decades U.S. investors’ returns on foreign equities and bonds have exceeded foreigners’ U.S. returns by 6.21 percent and 3.72 percent, respectively, per year – In addition, composition effects: US external asset share in equity higher than US external liability share; + equity risk premium – Hausmann & Sturzeneger (2005): “Dark matter” – Other contributors: Buiter (2006), Cline (2005), Curcuru et. al. (2007), Gros (2006a,b), McKelvey (2005), Obstfeld & Rogoff (2005), O’Neill & Hatzius (2007) 11 When all else fails, look at the data • Equity and bonds: – Curcuru, Dvorak & Warnock (2007): 1994-2005: no difference in returns on combined bond and equity portfolios; there is a composition effect but US has a negative yield differential for both bonds and equity. – Risky bonds: (Buiter (2006)); non-performing interest accrues in foreign factor income account until it gets formally written off/down or restructured. When it gets formally written off, it goes through the (new-style) capital account. If it never gets restructured, who knows….. 12 • FDI – Do we believe the (flow) balance of payments data or the (stock) foreign assets and liabilities (gross & net International Investment Position) data from the BEA ? – BoP data record transactions (cross-border payments and receipts flows) except for ‘reinvested earnings’ (in foreign factor income account); improves the US current account by about $50-100 billon per annum (foreign firms report systematically very low profits for their US-owned operations). 13 • Little difference as regards distributed earnings between US FDI abroad and foreign FDI in the US. Massive difference between reinvested earnings, which are negligible for foreign FDI in the US. – Reinvested earnings are calculated from surveys as difference between reported profits and repatriated profits. – Higher reported profits by foreign affiliates of US firms do not bring immediate additional tax liability: US tax deferred until repatriation – Higher reported profits by US affiliates of foreign firms (usually incorporated in US), bring immediate tax liability – Capital gains on FDI (corrected for re-invested profits), estimated from capital gains on portfolio equity. • No reported data that are tax-driven should be believed 14 As Grey Matter triumphs over Dark Matter: • Yes Virginia, the US has a large (probably > 30% of GDP) negative NIIP and non-negligible true net foreign factor income, probably between 1.5 and 2.0% of GDP. • The US trade balance deficit is just over 6% of GDP • So what? • Sustainability: 15 Some sustainability arithmetic l sp rp  g p (1) l :  NIIP as a share of GDP s p : permanent primary (current account minus net foreign factor income) as a share of GDP rp : permanent real rate of return on NIIP g p : permanent growth rate of real GDP 16 US Current Account Sustainability Arithmetic • Some illustrative numbers: l  30%; rp  4.0%; g p  3.0%  s p  0.30% of GDP or l  30%; rp  5.0%; g p  3.0%  s p  0.60% of GDP Unless we are in a Ponzi world with rp  gp any country with negative NIIP will have to run a permanent primary surplus if it is to remain solvent. So the US trade balance deficit will have to be reduced permanently by at least 6 percent of GDP, if there is to be no default. 17 Some unpleasant trade balance arithmetic    X ( , Y )  M ( , Y )  Y Y :trade balance surplus as a share of GDP :export volume (in units of GDP) : import volume : real domestic GDP b b X M Y  * 1 (2) Y * : real foreign GDP  : terms of trade (relative price of exports and imports) If follows that:   x b  1   X ,    , m   Y (b   M ,Y m) Y *  Y  X ,Y * x * Y     m   (3) 18 What is the magnitude of the required trade balance correction? US Current Account Balance 2 1 05 20 03 20 01 20 99 19 97 19 95 19 93 19 91 19 89 19 87 19 85 19 83 19 81 19 79 19 77 19 75 19 73 19 71 19 69 19 67 19 65 19 63 19 61 19 19 59 0 (% of GDP) -1 -2 -3 -4 -5 -6 -7 Current account balance (% of GDP) Trade balance is very close to the current account balance throughout. 19 % of GDP 19 80 19 81 19 82 19 83 19 84 19 85 19 86 19 87 19 88 19 89 19 90 19 91 19 92 19 93 19 94 19 95 19 96 19 97 19 98 19 99 20 00 20 01 20 02 20 03 20 04 20 05 20 06 Spain: current account surplus (% of GDP) 3 2 1 0 -1 -2 Current account surplus (% of GDP) -3 -4 -5 -6 -7 20 But the winner is: LATVIA! Latvia's External Balances (% of GDP) 30 20 (% of GDP) 10 Current account Current account (excl. reinvested earnings) 0 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Trade balance -10 -20 -30 21 The other side of the US ‘imbalance’ China's current account balance 8.0 6.0 2.0 Current account balance (% of GDP) 04 03 02 01 00 99 98 97 96 95 94 93 92 91 90 89 88 87 86 85 84 83 05 20 20 20 20 20 20 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 19 82 0.0 19 (% of GDP) 4.0 -2.0 -4.0 -6.0 22 Back to the USA: • With exports 10.0% of GDP and imports 16.5% of GDP in the US: b  0.06; b  0.06;  x  m  1; x  0.10; m  0.165;  M ,Y  1;  X ,Y * 1 Y  with constant terms of trade,  0.267 Y or   with constant domestic output,  0.60  23 Marshall-Lerner Torture: • To achieve a 6 percent of GDP increase in the trade balance surplus requires a 26.7 percent reduction in domestic GDP • To achieve a 6 percent of GDP increase in the trade balance surplus requires a 60 percent reduction in the relative price of exports • Reasons – low relative price elasticities – imports and exports are small shares of GDP 24 Some rather more pleasant trade balance arithmetic • Even in this exclusively demand-oriented approach, growth in the rest of the world will help out. • The income elasticities of export and import demand are likely to be greater than 1 (ratios of exports and imports to GDP have been rising). This is good news for the trade balance if there is robust global growth and if domestic demand contracts. 25 Some much more pleasant trade balance arithmetic • • • View import demand as the excess of domestic demand for importables over domestic production of importables/import-competing goods View exports from the supply side as the excess of domestic production of exportables over domestic demand for exportables 2 types of goods 1. Traded (or tradable) – Exports (or exportables) – Imports (or import-competing goods) 2. Non-traded 26 Marshall-Lerner de-fanged  • 2 key relative prices  – Terms of trade (relative price of exports to imports): – Relative price of traded to non-traded goods or real exchange rate: But for trade balance adjustment,  does all the work!  • 2 key intersectoral resource reallocations: – Between traded and non-traded sectors – Within the traded sector between exporting and import-competing sectors. • Lower domestic demand (‘absorption’) reduces imports and increases exports at given terms of trade & real exchange rate 27 Intersectoral resource movement: the key to trade balance adjustment • A depreciation of the real exchange rate (at given terms of trade & aggregate demand and resource utilisation) – shifts resources into the production of tradable goods, i.e. increases the domestic production of exportable and import-competing goods. – reduces the domestic demand for tradable goods, i.e. reduces domestic demand for exportable and import-competing goods exports increase and imports 28 decrease • The alternative perspective on the trade balance can be represented as follows: X   1 M b Y X  QX  DX (4a) M  DM  QM (4b) QN  DN (5) 29 I needed another slide for a continuation of the Notes page associated with the previous slide. These are two very well-balanced cats. 32  T qT ,   A T A d T ,    T b   q  d   d    Y    Y  but note that (7) A  1 b Y So, using this or (equivalently) the non-traded goods market equilibrium condition (5) we find:      dN (8)  b    qT  qT ,   d T A  d T ,    Y  where d N  1  d T is the share of domestic demand spent on non-traded goods 33 with: qT  0.5 d N  0.5 A  1.06 Y  qT ,   dT , 1 A reduction in the trade balance deficit by six percentage points of GDP requires a depreciation of the real exchange rate of 2.9 percent (and, of course, a reduction in the ratio of domestic demand to GDP by six percentage points) 34 For the pessimists: Of course, if you believe m  0.156 1.06 then the same 6% of GDP reduction in the trade balance deficit qT  x  0.10 and d T  would require a 26.2 percent real exchange rate depreciation (and still, of course, a 6 percentage point reduction in Key point: tradable does not mean actually traded today, especially given a bit of time. 35 A ) Y USA • The US has the most flexible economy in the developed world • There is considerable inter-regional labour mobility • Real wages and real unit labour costs have proven to be very flexible. • Many goods and services that were non-tradable have become tradable thanks to improvements in communications, transportation & ICT generally (i.e. thanks to globalisation and the internet). 36 China • China’s real exchange rate is not significantly undervalued as long as there is an ‘Arthur Lewis-style’ unlimited supply of labour from the country side, ready to move into either the traded or the non-traded modern sectors. • China’s nominal exchange rate is undervalued • Having the public sector manage the bulk of the nation’s foreign assets is a bad idea. • Having the central bank manage the bulk of the nation’s foreign assets is a very bad idea. 37 China ctnd • China is ‘too open’ as regards international trade, given its size and level of economic development • This is not inconsistent with the view that China ought to liberalise its service sectors, including financial services, open them up to foreign competition. 38 China's trade openness 70 60 (% of GDP) 50 40 Import share of GDP (%) Export share of GDP (%) Trade share of GDP (%) 30 20 10 0 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 39 • China needs to shift resources into its non-traded sectors, and reduce both domestic saving and (environmentally destructive) capital formation. • This resource re-allocation will not be a problem. Between now and 2030, another 350 million people may move into the cities. Labour force is highly motivated, skilled, flexible, mobile; independent unions are weak because of totalitarian government. It will not require serious real appreciation of the Yuan. • China will remain a high saving country, with likely persistent current account surpluses – Life-cycle reasons (demographics – one child policy; weakening of private provision of soc. sec. through ‘dynastic’ and extended families; inadequate state-funded social security retirement programmes) – Greater role for private funding of education – Precautionary saving: greater role for private funding of health care 40 Conclusion • The large current account imbalances (US, China, commodity exporters) are not a problem. • No coordinated action to reduce/eliminate these imbalances is required • Latvia has a current account problem - or rather an explosive credit boom, one of whose manifestations is a very large current account deficit. The US does not. 41 Conclusion ctnd • There are serious global problems 1. Underpricing of credit risk 2. Still abnormally low long-term real interest rates 3. Span of control of financial regulators/supervisors does not capture many new institutions and instruments 4. Properties of new contingent claims poorly understood; not stress-tested in real credit crunch; exposure to new contingent claims unknown to regulators/supervisors 5. Protectionist threats 6. Central banks behind the curve in the face of re-emerging global inflationary pressures 7. Environmentally unsustainable production and consumption patterns in the US, China and India especially. • But don’t worry about current account imbalances 42 (except perhaps in Latvia)