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Implications for Trade and Economic Growth
By Barry P. Bosworth, Masahiro Kawai
Brookings Institution PressCopyright © 2015 Asian Development Bank Institute The Brookings Institution
All rights reserved.
Overview of Issues, Challenges, and Policy Directions
BARRY P. BOSWORTH AND MASAHIRO KAWAI
The global financial crisis has provided vivid evidence of an interconnected world economy. A financial meltdown that began in the United States quickly spread to Europe, and both regions entered into a severe economic downturn. The disruption ultimately radiated throughout the rest of the world through its repressive effects on trade flows. The magnitude and breadth of the recession demonstrated the strength of the global linkages and the need for a coordination of national policies to achieve a complete recovery.
The world economy is emerging from that recession, but the pace of recovery varies greatly across the major regions. Most emerging market economies have returned to growth rates close to those in the precrisis period. Their financial systems were not significantly damaged in the crisis, and the restoration of global trade has returned them to the precrisis situation; growth is slower than before but remains strong, and their most pressing concern is inflation. However, the high-income countries of Europe, Japan, and the United States were more severely impacted, and they remain mired in more difficult circumstances. This is particularly notable in the eurozone economies. The recovery of their financial sectors remains incomplete; they are plagued by excess capacity that suppresses domestic investment and by high unemployment and low inflation. In high- income economies, the effort to stimulate their aggregate demand during the crisis left them with large fiscal imbalances.
The global recession occurred at a time of large external imbalances in the global economy. In an open trading system, individual countries should not expect nor desire to maintain persistent surpluses or deficits in their external trade balances. But large continual deficits by individual countries do raise concerns about the sustainability of their ever-growing debt burdens. And, if the countries are large and their financial liabilities are liquid, they raise the threat of disruptive adjustments that cause systemic problems for the world economy. Similarly, large enduring surpluses at undervalued exchange rates raise concerns about the accumulation of low-return reserves and difficulties for the operation of monetary policy. Thus there was considerable concern that a pattern of large offsetting trade imbalances might raise a systemic threat to the world economy. Although external trade imbalances were not the primary cause of the financial crisis of 2008–09, many believe that they were an important contributing factor.
The disruption of financial markets, the collapse of global trade, and the unemployment concerns of the Great Recession temporarily shifted the focus of policy away from the issue of external imbalances. Global imbalances have shrunk, but an examination of the underlying causes suggests that much of the improvement is likely to prove temporary. The magnitude of the fall in trade was much greater than expected from past recessions, and some of that could be traced to large swings in commodity prices rather than the volume of trade. In addition, the synchronous nature of a financial crisis triggered by events in the world's two largest economies, the United States and Europe, led to a greater-than-normal fall in exports and imports. Furthermore, equiproportional reductions in exports and imports lessened the imbalances for the large surplus (People's Republic of China, or PRC) and deficit (United States) countries. Thus there is an expectation that recovery of the global economy will bring with it a reemergence of large imbalances.
On the other hand, some changes in the underlying pattern of saving and investment in the United States and East Asia suggest that portions of the rebalancing may prove to be more permanent. Private saving has surged in the United States, and, given the magnitudes of capacity overhang, residential and business investments are unlikely to recover for the foreseeable future. At present, those factors have been more than offset by the magnitude of increase in government dissaving, but a reduction of the budget deficit, even though gradual, would imply a substantial improvement in the saving-investment balance within the United States. Similarly, the PRC's current account surplus has remained well below precrisis levels, and there has been an accelerated growth of domestic demand, particularly fixed investment.
In any case, there has been some change in the perspective and concern with the current account imbalances. Before the financial crisis, the focus was on the sustainability of a world of large external imbalances, a fear that the growing cost of the U.S. indebtedness in particular would ultimately prompt a correction that could be disruptive to the global economy as a whole. After the crisis, the concern has been with the implications of a two-tier economic recovery: rapid growth in the emerging markets and sluggish growth or even stagnation in the high-income economies. Particularly in the United States, a reduction in trade deficits—through an expansion in exports—is perceived as critical to achieving economic recovery. The absolute size of the imbalances has fallen, but in part for the wrong reason, as lower incomes in the United States have suppressed the demand for imports. A second important development has been the emergence at the 2009 Pittsburg summit of the G-20 group of countries as the central governance forum for the world economy. In its statements and the pledges of its members, the G-20 has clearly recognized the importance of coordinated actions to reduce imbalances in global trade flows.
Defining the Problem
The determinants of the current account are embedded within an interdependent system in which the external balance is driven by a combination of domestic and foreign factors. There are two principal perspectives on the current account. From the domestic side, the current account is equal to national saving less domestic investment, but from the external side, it is also equal to exports minus imports plus net income earned abroad. Thus the current account is defined by two identities: CA = S - I and CA = X - M + NFI, where CA is the current account balance, S is national saving, I is investment, X and M are exports and imports of goods and services, and NFI is the net factor income from abroad. One of the major sources of debate over the determinants of the current account in a specific instance is the extent to which it is driven by foreign versus domestic factors, but because the identities hold from both perspectives, outcomes are a reflection of both domestic and foreign economic developments. Since individual countries are part of a system in which they export to and import from a much larger global economy, their own specific balance is likely to be dominated by their own domestic determinants, saving minus investment, and the external balance adjusts through changes in the relative price of exports and imports; but large economies also have a determining effect on the global system as a whole.
The distribution of current account balances across major regions of the world economy is shown in table 1-1. National current account balances are shown as a percentage of world GDP for the period of 1980 through 2013. Before the 1970s, current account imbalances were strictly limited, as most national financial markets operated as closed systems. With the emergence of large-scale cross-border capital flows, countries have become capable of financing larger imbalances on a sustained basis. The major feature of the table is the dominant role of the United States as the source of the deficits over the past thirty years. At the same time, many of the other economies have a relatively small influence, since their deficits or surpluses have averaged small shares of world GDP. Japan used to provide a consistent offset to the U.S. deficits, but the magnitude of its surplus has declined since 2011. The offsets to the increased U.S. deficit appear to be large surpluses in the emerging economies of Asia, including the PRC, and the oil-producing economies of the Middle East and North Africa. Given the rise of oil prices, the surge of saving within the oil-producing economies is not a surprise, but the sudden emergence of a large current account surplus in emerging Asia is less expected. There is also a substantial current account discrepancy at the global level. Historically, the discrepancy was thought to arise primarily from the underreporting of investment income and transportation services, but in the past decade it has changed sign as countries are reporting more receipts than payments, largely in the area of business services (International Monetary Fund 2009, p. 35).
The dominant roles of the United States, Japan, and emerging Asia are highlighted further in figure 1-1. Their imbalances are marked by a large bilateral trade deficit-surplus between the United States and Japan until around 2000 and between the United States and the PRC since then. But a focus on recent bilateral trade flows can easily mischaracterize the nature of the imbalance because the PRC is part of a broader production network within Asia. It is often the terminal or assembly point for product components that are made throughout the countries of East and Southeast Asia. However, apart from the oil-producing countries of the Middle East and North Africa, the global trade imbalance is largely a product of economic developments in the United States and emerging Asia. As discussed above, there have been substantial declines in the magnitude of the two regions' trade imbalances since the global financial crisis. Major questions arise with respect to the durability of those changes.
Some insight into the domestic determinants of changes in imbalances is provided in figure 1-2, which reports rates of gross domestic saving and investment for four economic centers: the United States, Japan, the PRC, and emerging Asia excluding the PRC and India. The narrowing of the imbalance for the United States, which started in 2007, can be traced to the severity of that country's economic disequilibrium since it is the result of a collapse of both domestic saving and investment. The increase in the budget deficit far exceeded the rise in private saving, and national saving fell to near zero on a net basis, after adjustment for capital depreciation (not shown in the figure). The current account has improved only because of an even larger reduction in investment. Similarly, Japan suffered large declines in both saving and investment. In contrast, the PRC shows a moderation in domestic saving and a strong surge in investment. The investment to GDP ratio rose from 42 percent in 2007 to 48 percent in 2012, while the saving to GDP ratio declined slightly from 52 percent to 51 percent over the same period. Essentially, the PRC's current account surplus shrank mainly due to the sharp rise of domestic investment, which started with a 4-trillion-yuan fiscal stimulus package adopted in response to the global financial crisis (Kawai 2010). But this high investment ratio has created overcapacity and financial vulnerabilities, particularly in the shadow-banking sector, and is likely to be unsustainable. The separate treatment of the PRC also highlights a different pattern in the rest of East Asia, where saving has remained high since the late 1990s and investment collapsed as a result of the 1997–98 financial crisis without recovering much since then. India was little affected by the past crises, and it has maintained a very large, but balanced, increase in both saving and investment.
On the external side, changes in the balance of exports and imports are driven by differences in relative rates of domestic and foreign income growth, the relative prices of domestic and foreign production, and underlying structural factors that determine nations' propensities to export and import specific products. The concept of the real exchange rate provides a simple measure of relative prices, and it is defined as the nominal exchange rate (e), defined as the foreign currency price of domestic currency, multiplied by the ratio of foreign and domestic prices (Pd /Pf):
q = e × (Pd/Pf).
Figure 1-3 displays trade-weighted indexes of the real exchange rates, or real effective exchange rates (REERs), of the major countries and economies. The first panel contrasts the real effective exchange rates for the PRC and the United States to highlight the extent of departure in recent years. The United States has experienced a substantial depreciation of the real effective exchange rate relative to its peak in 2002, interrupted by a sharp but brief appreciation at the beginning of the financial crisis. Meanwhile, the PRC has had a substantial real effective appreciation since 2005, largely because of persistent nominal appreciation of the renminbi (RMB) against the U.S. dollar. The real effective appreciation of the RMB was also a result from substantial depreciations by some of the PRC's other major trading partners (such as Hong Kong, China; the Republic of Korea; and Taipei,China). The divergent trend changes between the U.S. dollar and the RMB are consistent with declines in U.S. deficits and Chinese surpluses.
Indexes of real effective exchange rates of the eurozone and Japan are shown in the middle panel, and they indicate a range of variation as wide as that for the PRC and the United States. Indexes for India and a composite of the emerging East Asian economies (excluding the PRC and India) are shown in the third panel. Except for the obvious effects of the 1997–98 Asian financial crisis, their exchange-rate changes have been small and largely free of a notable trend.
A Look Ahead
The objective of the following chapters is to examine factors that would achieve balanced, sustainable growth in the two regions, the United States and Asia, and the policy implications of these adjustments in both regions. The chapters that focus on individual countries address several specific issues, including the appropriate levels of domestic saving-investment (S-I) balances, the scope for policy changes to alter these balances, and the magnitude of exchange-rate changes required to switch the composition of demand between domestic and foreign sources and reallocate supply between tradables and nontradables sectors. There are also a series of major questions that we hope to address, and in some cases resolve. For example, why is saving so low in the United States, and what will be the effect on consumption of the recent wealth losses and of debt decumulation? Can the government budget deficit be brought back under control? What would be the required change in the real exchange rate to bring about the realignment of resources? On the Asian side, why is saving so high? How is the high saving distributed among the household, business, and government sectors? What needs to be done to promote domestic growth without creating or exacerbating external imbalances? Can growth be sustained at a high rate without a large stimulus of exports to the U.S. market? Finally, is it necessary to establish a transpacific mechanism to facilitate needed adjustments?
Transpacific Payments Imbalances: An Overview
Barry Eichengreen and Gisela Rua (chapter 2) provide an initial overview by surveying the existing literature on the causes of transpacific payments imbalances, analyzing past and current trends of these imbalances and drawing some implications for macroeconomic stability in both the United States and Asia. They argue for a comprehensive approach to rebalancing that takes into account two key points:
—adjustments of current account balances must occur simultaneously in both deficit and surplus countries; and
—adjustments in the composition of final demand will be accompanied by endogenous shifts in foreign exchange rates, export prices, and import prices to support the new current account balance equilibrium.
Excerpted from Transpacific Rebalancing by Barry P. Bosworth, Masahiro Kawai. Copyright © 2015 Asian Development Bank Institute The Brookings Institution. Excerpted by permission of Brookings Institution Press.
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