The Hindu Business Line : Half answers to global imbalance

The day of reckoning for the global current account imbalance, and the American dollar, is drawing closer. The Australian dollar might perform relatively better than its American counterpart, as it is backed up by real assets (oil, metals and minerals). Time should provide the answer. But, then, time has a way of providing frustrating half answers, says V. Anantha Nageswaran.

CREDIT SUISSE First Boston is a reasonably well-known Wall Street investment bank. Today, it is in the news for its restructuring efforts. A chart that one of its researchers produced did not make much news. It is a pity. Its fixed income research team based in London has developed a proprietary euphoria-panic indicator by combining a few global financial market indicators such as stock and bond yields in advanced and in growing economies, etc. This proprietary indicator reached `euphoria' high in the last ten days, seen last in March 2000.

While the index matching the level last seen in March 2000, just before the technology bubble burst, should serve as a warning to those who are exuberant (irrationally or otherwise), the rise of investor risk appetite has enabled a seamless flow of capital to current account deficit countries in the world, particularly America.

Sanguine on current deficit

The apparent ease of such funding has perhaps persuaded the Federa reserve chief, Mr Alan Greenspan, to be unconcerned about it. His testimony to the US Congress in mid-February did not discuss the current account deficit. The Federal Reserve Open Market Committee meeting too was cryptic on the subject. As per the minutes of its February meeting, it is clear that there is a karmic resignation on the issue: "external imbalance seemed likely to remain elevated, with a high level of uncertainty surrounding the prospects for and path of adjustment".

While there are some who argue that the current account deficit would easily be financed as the rest of the world has no option but to finance American consumption, it is clear that the market is nervous about it. A casual observation by the Bank of Korea that they might diversify their currency reserves out of the US dollar sent the currency tumbling last week. Clearly, the foreign exchange market is worried but the central bankers are not. The central bankers are puzzled by the low bond yield. But the bond market is bothered neither by the nervousness in the currency market nor by the central bank's own puzzlement. Economics is a frustrating science, if at all.

New paradigm on current deficit...

That apart, there are some who argue that what matters is not the current account deficit but profits, jobs and productivity. Andy Kessler, author of Running Money and Wall Street Meat, argues that America has moved from being an Industrial Production Economy (IP) to being an Intellectual Property (different IP) Economy. In this brave new world, America exports for free via an e-mail attachment (as simple as that) the design for the latest new chip to sweatshop chip-makers in Asia who labour to produce it at the cheapest possible price and send it back to the US. America then embeds the chip in the latest gadget (iPod?) and sells it back to wannabe Asian consumers with a hefty margin. In this stylised world, the trade deficit for the US is high. The design is sent virtually free and then the finished product is `imported'. Yet, America keeps all the margins. Sounds neat and may be there is a grain of truth to it.

... does not pass the test, yet

As the current account deficit spiralled out of control in the US, at least profits in the technology sector should have continued to remain elevated. But, national income statistics tell a different story. The chart below shows that the `Computers and Electronic Products' sector continues to generate losses.

Taking an even broader view, non-financial corporate sector profits have been merely cyclical (as a share of GDP) and have not shown any tendency to continue to rise, in line with the current account deficit. Whereas the latter seems structurally rising, the former has been merely cyclical. Instead, profits in the financial sector have risen from around 1 per cent of GDP to around 3 per cent thanks to vigorous mortgage lending. That does not have anything to do with the world of smart outsourcing described above.

So, the argument that the American current account deficit is an accounting artefact only is unconvincing. There is no proof yet that there is an extraordinary profit surge for American corporations resulting from it. The evidence is not even mixed.

Nor explains Australian current deficit

Further, across the globe, in Australia, a similar situation prevails. Indeed, by some measures, the Australian current account deficit is worse than that of America's and the household savings rate is deep in the negative territory.

In other words, Australians spend far in excess of their current income. It has been made possible by a booming economy, housing and stock markets. Stock market ownership among individual households in the world is probably the highest in Australia.

Further, the explosive rise in Australian home prices has made households feel a lot richer and they have been able to borrow against their home values or encash the gains. As in the case of the US, there is no significant gain in corporate profitability, resulting from the high current account deficit. It appears that, in both the countries, the more proximate and compelling cause of the deficit seems to be excessive domestic demand rather than any new-paradigm economics.

Thus far, the current account deficit has been well funded. In years gone by, the Australian currency would have come under severe pressure by now. This time around the currency's resilience has been remarkable. Australian interest rates are well ahead of rates in most other advanced economies. Further, the appetite for resources has meant that exports of basic metals and other resources to China continue to rise impressively.

Hence, the question is what happens to the Australian dollar and the economy if the US economy cools and so does the Chinese economy, in its wake. As an aside, one of the well-known Sinophiles, Stephen Roach of Morgan Stanley clearly says that China is lacking in self-sustaining domestic demand.

If that is the case and if the US slows down, Australian exports might come down and cause the current account deficit to widen even further. It will be interesting to see if the Australian dollar holds up in such a scenario. Global currency re-alignment may well become inevitable.

Economic policy is not vacuum-sealed

In the end, it appears that the response of central bankers to the bursting of the technology bubble, the September 11 terrorist attack and the emergence of China has resulted in asset price-led consumption causing current account deficits.

Whether central bankers should have done more to curb demand stoked by asset price gains is still a matter of debate. Such a move would never have political and popular backing as asset price inflation is always and everywhere welcomed. Further, some question the moral right of central bankers to inflict pre-emptive pain on the economy to address the current deficit that is being well funded for now.

However, it is worth remembering that if Australia and America had gone to the IMF to be bailed out, both would have received a policy package prescription of higher rates, fiscal restraint, lower aggregate demand and weaker exchange rates.

It is the hunch of the author that the day of reckoning for the global current account imbalance and the American dollar is drawing closer.

The Australian dollar might perform relatively better than its American counterpart might, as it is backed up by real assets (oil, metals and minerals). Time should provide the answer. But, as a seasoned global observer put it, time has a way of providing frustrating half answers.

(The author is founder-director, Libran Asset Management (Pte) Ltd., Singapore. The views are personal. Address feedback to van@libranfund.com)

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