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Shared Responsibilities: Solving the Problem of Global Imbalances, Speech by Rodrigo de Rato, Managing Director, International Monetary Fund
February 3, 2006
As Prepared for Delivery
1. Good morning. It is a pleasure to be back here at Cal. I would like to talk today about the situation in the global economy, and especially about the problem of global economic imbalances. The phenomenon of economic imbalances between countries is not new, but globalization has profoundly affected both the size and the nature of such imbalances. For example, without globalization, a United States current account deficit at its current level could not be financed. On a visit to the west coast, with its many Asian cultural influences, it seems appropriate to focus in particular on the roles of the United States and, especially, Asian countries in the world economy, and in solving this problem. I will also talk about the role of Asian countries in the IMF. But before I do so, let me say a few words about the current outlook for the global economy, and also a few words about some proposals that U.S. Treasury Undersecretary Adams made yesterday on the IMF's role in surveillance of exchange rates. I'll begin with these.
2. Yesterday, Undersecretary Adams made several proposals, including clarifying the principles of IMF surveillance over exchange rate policies, more substantial and pointed discussions of exchange rate issues in our annual Article IV Consultations with members, and more quantitative multilateral assessment of exchange rates in systemic countries. I found Mr. Adams' proposals interesting and constructive, and work is already underway in the IMF to enhance our exchange rate surveillance along similar lines. I'm looking forward to continuing discussions with all of our members on this in the months ahead. I note that Mr. Adams was careful to stress that his proposals are of general relevance, and are not directed at a specific country. I think that this is a good approach, and we will certainly look at the proposals in that light.
3. Let me turn now to the global economy. The last couple of years have been good times for the global economy. World output growth in 2004 was the highest in three decades, at over 5 percent, and our latest estimates suggest that global real GDP growth was around 4 percent in 2005. We also expect growth to continue at a good pace in 2006, despite recent shocks, including higher oil prices. The great engines of growth continue to be the United States, and the emerging economies in Asia, where growth is estimated at almost 7 percent in 2005 and is expected to be similarly strong this year. Growth in China, as many of you know, continues to be exceptionally strong: almost 10 percent last year.
4. This strong global growth has occurred without a significant pickup in inflation, which remains moderate, despite the hike in oil prices. In the major industrial countries, and increasingly in most emerging markets, inflation expectations are generally well-anchored. International financial market conditions have been benign for quite some time, and the resilience of many countries' financial systems has strengthened in recent years.
5. The great question is whether this state of affairs will continue, or whether there are underlying pressures that have the capacity to end it. The answer is that while there are risks, they are manageable. The global economy can keep growing at a good pace. But only if the major players act to contain some risks, and address some problems, especially the problem of global imbalances.
6. Let me talk about the risks first. Obviously there are events that could do a great deal of damage. In this category I would place a further significant increase in oil prices, and an avian flu pandemic.
7. There is not much that economic policy makers can do to influence world oil prices in the short term. But there are steps that policy makers can take over the medium-term. Oil producing countries can begin to increase investment in new facilities. Oil-consuming countries can increase refining capacity and take measures to curb oil demand, such as improving conservation and energy efficiency—steps that would also be good for the environment. And those countries that have reacted to higher oil prices by increasing subsidies instead of passing on price increases should seek a more efficient way to relieve their impact on the poor.
8. We all hope that an avian flu pandemic will not happen. If it does, it would have devastating effects on the world, and the main focus of the international community is rightly on minimizing the risks and human consequences of a pandemic. But it would be useful for economic policy makers to consider the economic implications of a pandemic: for trade and for financial and payments systems in particular, and think about what can be done now and what would need to be done in the event of a crisis. The Fund is working actively on this issue, and we are preparing to share best practices that are being established by institutions particularly advanced in this area.
9. Let me now turn to the problem of global imbalances. While global current account imbalances have been widening, the fact that they have been financed easily thus far seems to be inducing a sense of complacency among policy makers. I think that they should be more concerned. This is not to say that the risk of a disorderly adjustment is imminent, but the problem is growing, and if a disorderly adjustment does take place, it will be very costly and disruptive to the world economy. Moreover, the policies needed to reduce its likelihood are in the medium-term interests of the countries involved, so why not undertake those policies today? This is indeed what the IMF has been urging—a sensible risk management approach to international policy.
10. I'll talk about the actions that are needed in a few minutes. Let me first set out what I see as the problem. The most visible aspect of the global imbalances problem is a very large deficit in the current account of the balance of payments of the United States—amounting to about 6¼ percent of GDP and a correspondingly large surplus in the external accounts of other countries, including oil exporters such as Russia and Saudi Arabia, Japan and the countries of emerging Asia, and most particularly China. In some of these countries, and again especially China, current account surpluses have been accompanied by a very large build up of reserves by central banks. And in the United States repeated current account deficits have resulted in growing external indebtedness.
11. I should say in passing that some have denied that such indebtedness exists, pointing to the positive net investment income of the U.S., and arguing that U.S. assets—claims on non-residents—must be understated. This is the so-called "dark matter" hypothesis. I don't agree with this: there are good reasons why investment income can be a misleading indicator of the debt position, including higher returns on investment outside the U.S., reflecting higher risks, and transfer pricing by corporations to minimize taxes. Investment income has also been volatile in recent years, which does not suggest a stable relationship with the debt position. We in the IMF believe that the debt and the U.S. current account deficit are all too real.
12. Current account and financial imbalances are only part of the story. What underlies them is different patterns of saving and investment in the United States and emerging Asia.
13. The main problem is that in the United States savings are too low. The U.S. saving rate has been on a downward trend for the past decade, which has accelerated in recent years owing to the effects of the housing boom. Meanwhile the fiscal deficit remains high: the Congressional Budget Office last week projected that after falling in fiscal year 2005 it would increase again in fiscal 2006, to some US$337 billion, or even more when the costs of federal flood insurance and additional spending on the war in Iraq are counted.
14. In emerging Asia on the other hand, savings are relatively high, but in recent years most countries in emerging Asia have suffered an investment drought. In the past five years, investment in emerging Asia excluding China has averaged about 25 percent of GDP, about 7 percentage points of GDP below its average in the five pre-crisis years. The situation is different in China, in that both investment and savings have increased sharply in recent years. It was recently estimated at about 45 percent of GDP, though a recent revision to China's GDP numbers will probably bring this number down. In China, high precautionary saving leading to relatively low consumption is the main reason why China is still running very large surpluses in the current account of the balance of payments.
15. Why should these flows not be sustained indefinitely? After all they have lasted for a long time. For years there have been expectations that U.S. consumption would fall—following the bursting of the stock market bubble in 2000, for example—but it has proven to be remarkably resilient. Projections of a decline in China's growth have not materialized either. China appears to have undergone neither a "hard landing" nor a "soft landing" last year, but rather a mid-air refueling. Why should it not carry on flying high forever? And on the financing side, foreign investors and central banks seem to have an undiminished appetite for U.S. dollars. Why should they not simply continue to finance U.S. consumption?
16. Of course, many features of the economic landscape that seem permanent eventually cease. There was, after all, a widespread assumption that the boom in emerging markets in the mid-1990s and the technology bubble in the United States would continue indefinitely. And there are good reasons why countries cannot sustain very rapid growth rates over a very long period: for example capacity constraints and diminishing returns to investments. And recent gyrations in the oil market are a good example of how fast economic assumptions can change.
17. There are two obvious ways in which global imbalances could unwind quickly, and in a very disruptive way. One would be an abrupt fall in the rate of consumption growth in the United States, which has been holding up the world economy. U.S. consumption growth has to slow because the negative household savings rate is unsustainable, and it will slow, perhaps on the back of slowing house price growth. But if it slows abruptly, it will take away a major support from world demand before other supports are in place. Such a fall could also reduce domestic demand in other economies, for example in Europe and China, because demand for their exports falls. In this scenario, there would be a contraction of global demand, with only moderate correction of current account imbalances.
18. Another possibility is that adjustment is forced by the financial side, because the real side is seen as unlikely to adjust on its own. Investors become unwilling to hold increasing amounts of U.S. financial assets, and demand higher interest rates and a depreciation of the U.S. dollar, which in turn forces U.S. domestic demand to contract. Again, if this happens abruptly, it could cause a slowdown in demand and output, as well as financial market disruptions. And in either scenario there is a risk that economic damage would be worsened by an upsurge in protectionism.
19. The key challenge then is to unwind global imbalances gradually. To do this, it is important to abandon the pretence that global imbalances don't matter or will cure themselves. I hope that I've said enough to dispel thoughts that imbalances don't matter. As to whether they can cure themselves, there are two issues. First, in large part the imbalances are fueled by government actions, especially U.S. fiscal policy, and exchange rate and structural policies in Asia. I will return to these points in a moment. Second, if imbalances are left to cure themselves, there is a much greater likelihood of the kind of abrupt and disorderly adjustment that would cause serious problems.
20. It is also important that global imbalances be seen as a shared responsibility by governments in systemically important countries. This will make the necessary actions both politically easier and economically more effective. Politically easier, because instead of finger-pointing and recriminations you get mutual support and burden sharing. Economically more effective, because as demand is withdrawn in the United States it is added in Europe and Asia, and as financial flows from Asia become less available, so they become less necessary in the United States. To quote Ben Franklin, at the signing of the Declaration of Independence, this is a case where we must all hang together, or assuredly we shall all hang separately.
21. I have talked mostly so far about the imbalances between the United States and Emerging Asia, and I will return to these in a moment. But the other economic powers, Europe and Japan, also have an important role to play. Both have their own problems. Japan has been beset by deflation, and is already experiencing the economic effects of an aging population, which constrain what it can do in terms of fiscal policy. Europe has a current account position which is broadly balanced, and has its own fiscal constraints and emerging aging problem. But both also suffer from structural rigidities—for example uncompetitive labor and product markets—that have held back growth. Actions taken to address these problems will benefit their own economies and can support global growth by adding to demand as well as supply, and help offset a withdrawal of stimulus in the United States. In a number of European countries there is also a need to address fiscal problems. Many countries remain unprepared for population aging, with labor utilization and productivity growth too low, and public deficits and debt too high. What is needed is a convincing plan to improve public finances, raise participation in the labor force—which will probably require reform of welfare benefits—and improve productivity through increased competition. Removing rigidities is also important in Japan, and the recent invigoration of structural reform under the Koizumi government is an important positive development.
22. Oil-producing countries, which now also have very large current account surpluses, can also do their part. Specifically, those oil-producing countries whose macroeconomic positions are sufficiently strong can help by increasing productive spending, including in some cases social spending, in priority areas.
23. It is particularly important, and increasingly urgent, that the United States tackle its current account deficit by increasing domestic saving. Reducing the fiscal deficit has an important role to play in this. The U.S. administration recognizes the need for deficit reduction, but its plans are focused almost entirely on proposals for unprecedented cuts in spending. These would have been difficult to achieve even before Hurricane Katrina. Uncertainties about the costs of operations in Iraq and Afghanistan and the reconstruction of the Gulf Coast, and the difficulty of curbing entitlement spending, cast further doubt on the realism of the current deficit reduction plan. Meanwhile, on the revenue side, the administration seems to fear that the benefits of any revenue raising measure will be lost, as it is used as an excuse for more spending. This should not be the case, and it need not be the case. The administration and the Congress themselves control both taxes and spending, and action on both is needed to reduce the deficit. With this in mind, I hope that policy makers will give more consideration than they have so far to an energy tax, and also to the measures suggested by the President's Advisory Panel on Federal Tax Reform. In particular, the panel's report contains welcome suggestions on shifting the tax burden from saving toward consumption, which could improve the efficiency of the system, and on how to streamline and simplify the tax code. It is also critically important to reform entitlements, and to address the problems of social security and Medicare.
24. The countries of emerging Asia and especially China can take action in several areas. Let me talk first about China's exchange rate policy. China took steps a few months ago toward greater exchange rate flexibility, revaluing slightly and allowing for the possibility of further movements in the exchange rate each day. Since then China has taken further steps which should promote flexibility over the medium term. It has increased the number of financial institutions licensed to participate in the inter-bank market, and in particular foreign bank participation has increased. It has also allowed trading of forward foreign exchange contracts to foster the development of instruments to hedge foreign exchange risk. But so far there has been very little actual movement in the exchange rate. Could China go further? Absolutely, and I hope it will. The IMF has been in the forefront of advising China to liberalize its exchange rate regime. The change China made in its regime in July last year was a move in this direction, and since that time, we have strongly urged the authorities to fully utilize the flexibility that the new regime allows. We believe that doing so would lead to an appreciation of the currency and would tend to reduce China's current account surplus. But the decision must come from the Chinese authorities. The IMF's job is to persuade them of the merits of liberalization, and advise them on managing the process. This is what we have been doing, and the steps that China is taking, gradual as they are, suggest that the Fund's strategy is working. I should also add that China's is not the only Asian currency exchange rate that matters. It is important that other countries in Asia that have been allowing more flexibility in their exchange rates continue to do so. And this has certainly been happening, notably in Korea, and in other countries too.
25. However, exchange rate adjustment in China and other emerging Asian economies alone would not be sufficient to deal with the problem of global imbalances. Studies that the IMF has conducted show consistently that it would play only a limited role, and that action by other countries along the lines I have discussed would do more. In addition, it is not just exchange rate adjustment, but broader policy reform that is needed in China and other emerging Asian countries. Specifically, structural reforms to encourage faster domestic demand growth in Asia—including reforms to encourage higher investment in some countries and more productive investment and higher consumption in China—should be part of an orderly adjustment process.
26. There are many steps that emerging markets could take to boost investment. Much progress has been made in reforming financial sectors in emerging Asian countries since the Asian crisis. Significant progress has been made in bank restructuring, as evidenced by lower non-performing loans ratios across the region. However, improvements in bank profitability and risk pricing are still needed, and reforms that extend the reach of financial services—with proper regulatory oversight—would tend to stimulate both household consumption and investment. Efforts to broaden the sources of corporate financing would also help, as would measures to improve the investment climate, for example reducing entry requirements, promoting a level playing field for investors, and clarifying bankruptcy laws and the framework of labor relations.
27. China is in a different position from the rest of emerging Asia, because it's investment ratio is much higher. Indeed, the question in China is whether investment is sufficiently productive, and the best contribution that China can make to dealing with global imbalances is to increase consumption by reducing precautionary saving. Two ways that the Chinese authorities could do this is by rebalancing public expenditure towards greater spending on health and education, and by reforms to the pension system. Many individuals and families in China save a lot because they doubt that healthcare or pensions will be adequate to protect them in a time of need. Removing these doubts would both be a public service and encourage increased consumption.
28. Before I conclude, let me say a few words about the role of Asia in the IMF. Our relations with many Asian countries have been colored by the Asian crisis. I believe that the IMF did much good and useful work during the Asian crisis. But there is no doubt that our interventions were seen by some in Asian countries as intrusive, and sometimes insensitive. The Fund has been working hard to correct that impression in the years since, and to make sure that our advice is both useful to our Asian member countries and conveyed in a constructive way.
29. The relationship is important for many reasons. The IMF remains important to Asian countries. As with other members, we can give advice based on global experience. And the possibility and promise of financial support in times of need is also useful to Asian countries. Many emerging market countries have built up substantial external reserves since the Asian crisis, in a form of self-insurance. And in Asia especially there has been an attempt to develop regional financial partnerships, to give a further back stop in the event of crisis. But holding large reserves has costs, and regional financing arrangements have limits. As countries gain access to market financing, they become more prone to volatility in financing flows, and to contagion from financial events in other countries. And there are many countries in Asia which are still at a relatively early stage of integration into world capital markets. To be clear, I do not see any immediate crises on the horizon, but I would be surprised if the world proceeded as smoothly over the next ten years as it has in the last five. And the ability to obtain support from the IMF if and when it is needed remains important for Asian countries as it is for other members. So it is very important that support from the IMF remains available to Asian countries, and that it can be provided in ways that meet the needs of our members. This is an important consideration in the work on our role in emerging markets that is underway as part of the IMF's medium-term strategy.
30. It is also important that Asian countries have a role in the decision-making process of the IMF that accords with their growing importance in the world economy. The Fund's credibility with its members rests as importantly as anything on the Fund's perceived legitimacy as an international organization representative of its members. Our legitimacy suffers if we do not adequately represent countries of growing economic importance. This means, in particular, a need for increases in voting power for some emerging-market economies, especially in Asia.
31. IMF quotas, which determine voting shares, are a matter on which our membership must come to a political consensus. In considering this issue, they will need to consider the interests of the institution as well as their national interests. Indeed, I think the two are consistent. It may seem that if some countries get a larger slice of the pie, others must get a smaller one. But decisions on quotas are not a zero-sum game. If there is broad acceptance of the IMF's legitimacy, the institution and all of its members will benefit.
32. Thank you very much.
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