The Hindu Business Line : Global Economic Imbalances — Can US continue to feign ignorance?

The US may be happy living beyond its means but if it does not correct the imbalances it is causing world-wide, crude oil and other major commodities may soon be invoiced in non-dollar currencies. The rest of the world needs also to watch its step, instead of waiting for the market forces to mould some miracles. The US may be forced to correct its macro economic imbalances sooner than later.

The phrase `global payments imbalances' relates to the rising current account surpluses and deficits of different regions of the world and the consequent creation of massive international reserves, generally denominated in dollars, particularly by Asian and recently by Persian Gulf nations.

With rapid globalisation during the last decade, the problem has been further aggravated and, in fact, some economists even maintain that it has reached crisis proportions. Emerging economies, traditionally recipients of foreign capital, have now become the chief suppliers of capital, which has become crucial to financing inexpensively the large and growing current account deficit of the US.

Current account deficit of US

The US' current account deficit has reached seven per cent of GDP. Its fiscal deficit is at over four per cent level.

The US must now attract nearly $7 billion capital every working day from the rest of the world to finance its current account deficit besides meeting its foreign investment outflows.

Even a modest reduction of this inflow, let alone its stoppage or a sell off from the $12 trillion claims on the US now would bring down the dollar value significantly.

This could, in turn, steeply push up US inflation and interest rates, adversely affect its housing and equity markets and potentially trigger a recession in the US, in particular, and globally, in general.

Any other nation would have collapsed economically under the weight of the twin deficits but not the US, because of the very special key currency status the greenback enjoys.

The very low savings rate in the US, and its consumption boom under the wealth effect, continue to aggravate its twin deficits.

This position has been aptly summarised by an analyst thus: "When the rest of the world must toil hard to earn dollars, which are needed to buy goods internationally, or to pay off foreign debt, the US just needs to print dollars." Living on credit has become the credo of the US, evidently the largest debtor nation.

Are these imbalances sustainable in the long run? If not, what corrections are needed to bring sanity to the global economic system? Different regions of the world hold different perceptions in this regard. Therefore, reaching a consensus is difficult.

The US viewpoint

American economists argue that the higher rates of productivity growth in the US, aided by superior technology, have engendered corresponding differences in risk adjusted, expected rates of return and hence in the demand for US-based assets.

The decline of the `home bias' in investments by many nations in an environment of financial globalisation has positively contributed to this process. A larger number of US households and businesses, besides the Government, now fund their capital investments from substantial external sources.

These economists counsel the US to increase savings, reduce consumption and, more important, shed protectionist trade policies to come out of the twin deficits. They envisage that under sufficiently flexible market conditions, changing terms of trade, interest rates, asset prices and exchange rates, US savings will rise.

Mr Alan Greenspan, former Chairman of the US Federal Reserve, warned that, "if the pernicious drift towards fiscal instability in the US and elsewhere is not arrested and is compounded by a protectionist reversal of globalisation, the adjustment process could be quite painful for the world economy."

Obviously it is the world economy that has to bear a substantial burden and not the US! Perhaps the US citizens were right when they proclaimed some time ago: "The dollar is our currency but its problems are yours."

US: A smart investor

American citizens and corporates appear to be smarter investors than the rest of the world. According to some analysts, if their investments are properly valued from the perspective of the technical knowhow, lower historic book values, etc., the US may turn out to be a net creditor nation.

They cite the relatively higher returns on these assets in the form of dividends and interest payments besides capital gains.

The Asian viewpoint

Asian nations, especially China and India, have high savings and low domestic investment rates, forcing them to augment their foreign exchange reserves, to the extent of the difference between these two rates. Further, South-East Asian nations, in the aftermath of the 1997 economic crisis, have significantly slowed down domestic investments.

Asian nations are acquiring greater economic importance. Most of them follow a managed float system for currency management with dollar as the anchor.

They already have far more external reserves (bulk of them in low-yielding US treasuries) than they need for self-insurance against financial crisis and they are thinking of gradually shifting to the euro, the pound sterling or the Japanese yen.

They deliberately keep their home currencies undervalued to preserve their export competitiveness, and not to lose on account of capital depreciation of the dollar reserves.

China, for instance, revalued its currency by a mere 2 per centon July 21, 2005, evidently under pressure from the US (a significant revaluation of the Asian currencies will automatically reduce the US trade deficit).

Yuan revaluation to reduce deficit?

Will the revaluation of the yuan reduce the US trade deficit? Going by the experiences of Japan and Germany, it is not likely in the long run. The currency revaluations have only resulted in deflationary conditions in these two countries and higher inflation in the US, while the US trade deficit continue.

It is, therefore, obvious that the so-called flexible exchange rate policies can only offer short-term solutions. We need to understand that the huge Chinese reserves, in fact, reflect the low labour wages and social security benefits to its workers.

The long-term solution lies in radical structural reforms with regard to wages, rents and competition policies. Such reforms will redistribute the resources from the wasteful consumption of rich countries such as the US to productive consumption of the working class.

Developing economies and even Europe must enhance local demand and investments. Excessive reliance on export-led growth may not be rewarding in the long run, as proved in Japan's case. Japan, for example, has to come out of the deflationary spiral and embark on radical banking and trade reforms.

The US could be happy living beyond its means. It has no compelling need to proactively initiate steps for the reduction of its twin deficits, as halving its current account deficit will impose a burden of $2,350 per capita on it.

It is for the European and Asian, particularly the Persian Gulf nations,to correct the situation in their own interest through structural reforms, development of bond markets, regional currency regimes etc.

The world may very soon witness oil and other major commodities being invoiced in non-dollar currency. This way, the US may be forced to correct its macro economic imbalances sooner than later.

The rest of the world, therefore, needs to work in cooperation and more importantly, oppose the military adventurism of the US, in one voice. Otherwise, the global economy will pay a high price, should the correction to the imbalances be left to the market forces.

(The author is Associate Dean, ICFAI University, Hyderabad.)