Global Imbalances and Currency Misalignments
Outline of remarks at the World Economic Forum, Davos, Switzerland
© Peterson Institute for International Economics
1. The international adjustment process is starting to work:
a. The US current account deficit peaked in 2005 and has declined by about $100 billion (and is falling even more sustainably in real terms).1 Bill Cline's model as of December 28, 2007 projects that the deficit will decline to 4.3 percent of US GDP by 2011-12 if oil prices drop back to $60 per barrel (though remain at 5.6 percent of GDP with oil at $100).2
b. The US budget deficit has also narrowed, to about 1.2 percent in FY2007 (ending September 2007) (though much of this improvement is cyclical and renewed increases seem likely over both the short and medium runs on current policy; the budget should now be in surplus after the strong growth of the last few years).
c. The dollar has declined by a trade-weighted average of about 25 percent from its peak in early 2002. The decline to date has been gradual and orderly.
d. The euro and a number of other floating currencies, which have been the dominant counterparties during the Stage I decline of the dollar to date, have risen to or nearly to their equilibrium levels against the dollar (1 euro = $1.50) per the international consensus recorded by the Bruegel/KIEP/Peterson Institute conference on the topic in February 2007.3
e. Appreciation of the renminbi accelerated in late 2007 (though it remains weaker in real effective terms than at the dollar's peak in February 2002, and even over the past year, and we cannot know if the faster recent pace will persist).
2. Several serious adjustment problems remain, however.
3. First, the US deficit needs to fall by another 1 ½-2 percentage points of GDP to reach a sustainable level of 3 percent (at which the negative ratio of the net international investment position to GDP will ultimately stop growing, at about 50 percent).
a. This will require inter alia a further decline of 10-15 percent in the trade-weighted average of the dollar.
b. One key policy requirement is to make sure that this decline (plus any market overshoot) continues to occur in a gradual and orderly manner despite the likely swing in growth and interest rate differentials against the dollar, and perhaps a growing demand for structural diversification into euro as its role as a global currency continues to increase and perhaps accelerate, along with the continuing current account imbalances.
c. The other key policy requirement is to make sure that the coming Stage II decline occurs against the appropriate currencies, mainly those of the large Asian and oil exporting surplus countries.4
4. Second, the Chinese surplus is rapidly becoming a/the central global imbalance, with major adverse effects on a number of other developing countries (notably including India, Mexico, and a number of African countries) as well as the European Union and United States. It is now expected to reach about $400 billion for 2007, $450 billion in 2008, and $500 billion (11 percent of GDP) in 2009.5 China's global current account surplus could equal 75 percent of the US global current account deficit by 2009.
a. Hence it remains imperative for China to shift from export-led to domestic-led growth, for a number of "purely domestic" reasons (including investment efficiency, job creation, energy usage, and environmental impact) as well as to cut the external imbalance.
b. Merely cutting China's global surplus in half will also require a further renminbi appreciation of at least 30 percent against the dollar, which would amount to a rise of about 12 percent on a trade-weighted basis if the other Asian surplus countries permit and experience similar increases in their dollar rates. This obviously requires China to sharply reduce its massive intervention in the currency markets, which (at $40-50 billion per month) is now running at about twice the pace as in July 2005 when the country's authorities indicated that they were moving toward a more market-determined exchange rate.
c. An essential part of the adjustment process, both to achieve the needed global magnitudes (since the East Asians account for 40 percent of the trade-weighted dollar index) and to facilitate adequate renminbi appreciation, is to assure parallel currency movement among the other Asian countries with large surpluses: Hong Kong, Malaysia, Singapore, Taiwan, and especially Japan (which should publicly commit to avoid any oral as well as financial intervention until the yen has risen to at least 90:1 against the dollar). This could best be achieved by a formal or informal "Asian Plaza Agreement," orchestrated by the International Monetary Fund (IMF) or by China itself, to resolve the collection action problem whereby each country in the region (including China) is reluctant to permit substantial appreciation due at least in part to fear of losing competitive position vis-à-vis its neighbors.6
5. Third, there is considerable risk that these optimal realignments will not take place in an orderly manner (if they take place at all):
a. The decline of the dollar could accelerate sharply, especially if there are unexpected shocks like United States falling into steep recession and/or its financial conditions (and institutions) deteriorating sharply, and/or overshoot significantly its new equilibrium level. This would in turn hamstring US monetary policy and intensify the prospects for prolonged stagflation, perhaps forcing instead the use of fiscal policy with all its uncertainties, to stimulate recovery. An obvious policy response to preempt or counter this risk of a free fall and hard landing would be coordinated intervention by the G-7 and the major Asian surplus countries.
b. Continued resistance by China and other surplus countries to the required appreciations of their currencies could force most or all of the counterpart appreciations onto the euro and other freely floating currencies (including the Canadian and Australian dollars), replicating and extending the prior Stage I of the dollar decline rather than moving on to the desired Stage II for the future. In addition, continued real effective depreciation by oil exporters may add to their surpluses. Substantial new misalignments and imbalances could be created as a result.
c. To help prevent the risks of both a dollar free fall/overshoot and excessive euro appreciation, and thus to protect the world economy from a severe slowdown now and continued instability over time, it would be highly desirable to offer an alternative route to currency diversification by creating a Substitution Account at the IMF through which official holders could exchange their dollars for special drawing rights (SDR) or SDR-denominated claims. The details are in my recent op-ed in the Financial Times, and in the subsequent exchange of comments between IMF historian Jim Boughton and myself.
d. In addition, it should be noted that a simultaneous continued reduction of the US (especially real) deficit and continued growth of China's surplus could place considerable pressure on other countries and, in the absence of compensating policy initiatives by them to promote domestic demand, depress global growth. Substantial help could be provided by Russia, which is expected to experience a shift of $100-150 billion (from large surplus to modest deficit) in its current account position by 2009 as a result of sharp (probably excessive) fiscal and monetary expansion.7
6. The international policy agenda for the immediate future should thus focus on three initiatives, in addition to necessary national actions by the countries with the main imbalances (fiscal policy in the United States, reordered growth strategy and curtailed intervention in China):
a. Orchestration of an "Asian Plaza Agreement" to promote a geographically appropriate (Stage II) correction of the remaining large imbalances and currency misalignments;
b. Preparation of a contingency plan for joint intervention to slow the decline of the dollar if it threatens to accelerate into a free fall and hard landing and/or to check an excessive rise of the euro and other floating currencies; and
c. Prompt creation of a Substitution Account to limit the risk of dollar overshooting on the downside, and euro overshooting on the upside, over both the short and longer runs.
7. The final policy question is how to proceed if none of these steps can be achieved through constructive international cooperation, especially via the IMF:
a. In particular, the US Congress (and possibly a future US administration) might impose trade sanctions against the major surplus countries (notably China).
b. The European Union may also take additional trade measures against China (and perhaps Japan).
c. Hence the global trading system could be a major casualty of a failure to effectively resolve the macro and monetary imbalances.
d. The World Trade Organization (WTO) rules on currency misalignments, which have never been used and are probably inadequate in any event, should thus be reviewed in an effort to devise acceptable multilateral responses to exchange rate imbalances that are large enough to distort trade flows substantially and thus undermine the objectives of the global trading system.8 Congressional legislation that forces consideration of the linkages between currency misalignments/"manipulation" and trade policy could most constructively be channeled in this direction.
1. Higher oil prices and J-curve effects from the most recent dollar decline could produce a temporarily renewed increase in the nominal current account deficit in 2008 while real net exports continue to improve (with real exports growing more than five times as fast as real imports for the past year) and contribute positively to economic growth.
2. See William R. Cline, "Impact of the Lower Dollar and Higher Oil Prices on the US Current Account Balance," [pdf] November 2007.
4. A number of oil exporters peg to the dollar and are thus experiencing substantial depreciations on a real effective basis even as their external surpluses expand with higher oil prices.
5. Stephen Green, "Light at the End of the Trade Surplus Tunnel," Standard Chartered Bank, December 20, 2007. Nicholas Lardy of the Peterson Institute broadly concurs with this (curiously titled) analysis.
6. All of the countries cited, except Hong Kong, have managed floats and could simply curtail their intervention practices. Hong Kong-which wants to stick with its currency board instead of floating on its own-could either mirror a discrete revaluation by China and remain on the dollar or take the occasion to make the inevitable shift to a renminbi rather than a dollar peg and then float with the renminbi instead of with the dollar.
7. See Michael Marrese, "The Convergence of CEEMEA Countries with Developed Markets," JP Morgan, December 19, 2007.
8. See Aaditya Mattoo and Arvind Subramanian, Currency Undervaluation and Sovereign Wealth Funds: A New Role for the World Trade Organization, Peterson Institute Working Paper 08-2, Washington: Peterson Institute for International Economics, January 2008.