Who’s to blame for global imbalances?

Inclusive Economy16 Nov 2009Evert-jan Quak

Some interesting discussions about global imbalances took place at the conference ‘Recovery towards what? Finance, Justice, Sustainability’, organised by the Bretton Woods Project in London, on the 6th November 2009. Huge global imbalances emerged in the 2000s, caused by US current-account deficits and China’s current-account surpluses.

As recently as 1996, the net debtor status of the US was minus US$456 billion. Since 1996, it has increased by more than US$3 trillion, or 660%, as the country’s 12-year cumulative trade deficit soared by US$5.7 trillion. The creditors of US debts are mainly developing countries, especially China. An estimated 70% of China’s US$2 trillion in foreign exchange reserves – the world’s largest stockpile – is held in dollar-denominated assets.

China obviously invested their foreign exchange reserves somewhere. The home for them was in US Treasuries. But as the supply of Treasuries was limited, the Chinese invested more in other US bonds, such as those issued by Fannie Mae and Freddie Mac. By doing so, China actually invested dollars in the US to keep the US economy running and the value of the dollar high.

Some economists, especially in the US, have pointed fingers at China as the underlying problem behind the financial crisis. They argue that global imbalances were caused by China’s growing industrial labour supply and through manipulation of the exchange rate.

The overall response at the conference in London was the opposite, however – not to blame China, but the US.

1. First, the US is by far the biggest net capital importer, with a staggering share of 43 % of total global capital imports. China, on the other hand, is a much smaller net capital exporter, accounting for only 23% of total global capital exports.

2. Second, several other developing countries, especially in Asia, are big net capital exporters. Germany is the world’s second largest net capital exporter, with a share of 13 % of total global capital exports, but nobody asks nations such as Germany or Japan to decrease their exports. And no US economists ask dollar-rich, oil-exporting nations like Saudi Arabia to screw down their oil production.

3. Third, it was the Washington Agenda of the IMF and the World Bank, supported by the US government, which propagated export-led development in developing countries. To blame these countries now for global imbalances is unfair and far from the reality.

4. Fourth, it makes more sense for China’s exchange rate management to preserve the asset value of China’s reserves, not to stimulate more trade deficit in the US.

Global imbalances resulted in huge capital inflows from poor countries to rich countries. ‘By running current-account surpluses, emerging and developing countries are exporting their excess savings to rich countries, and to the US in particular,’ said Prof. Terry McKinley, director of the Centre for Development Policy and Research at the School of Oriental and African Studies. ‘This is a reverse flow of capital moving in the opposite direction to that of ODA. Poorer countries should not be financing a consumption binge in rich countries.’

He emphasized that investments in US Treasury Securities by developing countries will continue, despite the fact that the rate of return on these assets is low and their value is risky because of the continuing depreciation of the US dollar.

As some economists blame China, what options does China have? The dollar is going to be weak. When the value of the dollar plummets, China (and other developing countries) has a problem with its foreign exchange reserve. So, China wants to get rid of its dollars, but how? There are several options.

1. Foreign reserve allocation. One way is to create a Chinese Marshall Plan to stimulate domestic consumption and domestic investments. But as Prof. Gao Haihong, director of the Department of International Finance at the Chinese Academy of Social Sciences, said: ‘How can we consume more in China, as wages didn’t grow for years?’ There is another option – to invest more in Africa and Latin America. China already invests billions in developing countries, and already critics – especially in Europe – accuse China of neo-colonialism.

2. Chinese exchange rate policy. China could consider a floating exchange rate against the dollar, but this would hit political nerves. Gao Haihong predicts that in the coming years, there will be no dramatic de-pegging of the Renminbi (China’s currency) against the dollar, but more likely a gradual widening of the exchange rate band.

3. Financial openness. China actually has a low level of financial openness, which means that it doesn’t have much financial power internationally, despite being the world’s biggest net capital exporter. Without power, it will continue to be dependent on foreign countries with stronger currencies like the dollar, euro or yen.

4. Super currency sovereignty. The dollar is the world’s reserve currency, but is no longer a stable store of value. The dollar can be replaced by another currency, but this is unlikely to happen in the short term. The governor of the People’s Bank of China therefore supports an international reserve currency, disconnected from the currencies of individual countries, like the IMF’s Special Drawing Rights unit.

An alternative is to substantially devalue the US dollar, making its exports cheaper and imports more expensive – and thereby reducing the US current-account deficit, as Terry McKinley suggested. But if this option is taken, then relative to the US dollar, the currencies of many other countries with floating exchange rates would appreciate, worsening their trade balances, for example Brazil.

There is another alternative, as Prof. Robert Wade, professor of Political Economy and Development at the London School of Economics, showed in his presentation. Research shows that global imbalances and income inequality are related. In times of increasing income inequality, global imbalances also grow spectacularly. A trade deficit in the US helps to keep wages low, but a capital inflow boosts top incomes by inflating prices of stocks, bonds and real estate, whose ownership concentrates in the hands of high-income people.

First of all, he said, when income inequality rises, this must trigger regulators to be more alert and for governments to take action – for example in exchange rate policy. Exchange rates should be managed so as to maintain a sustainable balance of payment, with a trade balance high enough to meet obligations. The question is how to coordinate international exchange rates in line with the international objective of sustainable balances.

The alternative, Prof. Wade said, is a surveillance organization, independent of the wishes of nation states. The IMF cannot provide such surveillance anymore, because it is not independent and, even more importantly, it cannot lend money to governments and give advice at the same time.

Reform in the International Monetary System is more important then ever, in order to tackle global imbalances. The IMF predicts that the 2009 US fiscal deficit will reach 12.5% of GDP (and still be 10% in 2010). Such high fiscal deficits tend to enlarge the current-account deficit, by increasing imports through increased domestic spending (part of which is spent on imported goods). At the least, a new reserve currency is needed to prevent the US from re-growing on increasing debts that are mainly funded by developing countries.