Speech

Remarks by Raghuram Rajan, Economic Counsellor and Director of the Research Department, IMF

December 15, 2004

Remarks by Raghuram Rajan
Economic Counsellor and Director of the Research Department
International Monetary Fund
At the Australasian Finance and Banking Conference
Sydney, Australia
December 15, 2004

Even though the forecast for the world economy is relatively sunny, there are nevertheless some clouds:

· Despite very positive recent U.S. developments, job growth, which is critical to the economy going forward, is still not as strong as it should be at this stage of the cycle.

· In Japan, growth has slowed markedly, although the underlying basis for a return to potential growth remains in place.

· In the euro area, there are serious signs that growth will not attain the envisaged pace in the second half of 2004 and while we expect 2005 to improve, there are still uncertainties about the strength of recovery of domestic demand.

· In China, it is still not clear whether the authorities have been successful in slowing the quantum of investment and in improving its quality.

· Last, but certainly not least, the recent behavior of the dollar is a timely reminder of the risks posed by the unbalanced pattern of global growth and savings and its reflection in current account deficits and surpluses. I would like to focus my remarks this morning on global current account imbalances and how their adjustment might unfold.

The Dollar

The risk of a disorderly depreciation of the dollar has taken the spotlight recently. Suddenly everyone has turned their attention toward the large U.S. current account deficit and is questioning its sustainability. While the IMF has been repeatedly emphasizing the risks posed by global imbalances over the last few years, now that it is on everyone's mind, it is perhaps time to stock. Let us first outline where we stand at the moment.

(Chart: US CA and REER) The U.S. current account has been on a downward trend since it reached close to balance in 1991, with a more rapid deterioration since 1997. Concern about the current account has remerged as markets sense it is more likely to expand further than narrow, and as exchange rates have moved in anticipation. (Chart: Bilateral euro/yen) The Euro is now trading at historic highs relative to the dollar, though perhaps this statement over dramatizes the situation. If we trace the euro back to the time it lived as the Deutsche Mark and the French Franc—by creating a synthetic Euro before 1999 as in the chart—we still have some way to go to the historic high. (Chart: REERs) Perhaps more relevant are real exchange rates, and here we see again that euro real rates are still below their highs in the 1990s. Japan's real rate is well below its high in this decade, reflecting the fact that if a country has deflation, an appreciation of the nominal exchange rate is warranted just to keep the real level constant.

While there is much discussion about a disorderly adjustment, the market data do not corroborate it. (Chart: PDF euro/dollar) A comparison of the probability density function for the dollar/euro rate in January of this year with today shows a substantial euro appreciation, but the fatness of the tails, representing the probability of very large moves, has increased only slightly. (Chart: G3 volatilities) Volatilities of 3-month forward exchange rates are currently lower than they were earlier in the year.

Therefore, while there is no need to be alarmist about the current level, the depreciating dollar is a wake up call urging policy makers to pay attention to the problem of global imbalances. Before discussing what needs to be done, let us start by attempting to assign responsibility for the imbalances. (Chart: US C/A and S-I) The current account deficit essentially reflects an excess of investment over savings. In the United States, public savings minus investment have been negative through much of the last few decades. Private savings have, however, typically exceeded investment and have served to offset the public sector deficit. Towards the end of the 1990s, however, during the bubble years, private investment in the United States boomed while private savings increased only marginally. Therefore, even though the United States ran fiscal surpluses in 1999 and 2000, the current account deficit worsened. More recently, however, the United States has returned to running large fiscal deficits. Both the private and the public savings investment balance are now in deficit. So the U.S. government, the U.S. consumer, and U.S. corporations, all share some of the responsibility—though one must remember that without the fiscal stimulus and strong private consumption powering the U.S. recovery, the world might still be mired in recession.

(Chart: GNS) But the United States is not the only country in which savings has been falling: take a look at this chart reflecting national savings. It suggests that national savings have been declining in general, except for China and, for a brief period, the ASEAN countries. Savings have gone up by an astonishing amount in China, perhaps in part reflecting demographic transitions, and in part reflecting the transition from an economy with little competition and substantial implicit social security to one with substantial competition and little explicit social security. So perhaps the Chinese are responsible for consuming so little and saving so much. (Chart: I/GDP) But before concluding that, take a look at investment patterns. Chinese investment has increased to keep pace with savings. But investment in the NIEs and ASEAN fell considerably during and after the Asian crisis, and investment in Japan has been on a steady decline since the bubble years of the early 1990s. (Chart: S-I) While these are understandable developments given there is widespread agreement the investment in these countries was excessive and of poor quality in the early 1990s, when you look at gross national savings less investment, the counterpart of increasing U.S. deficits are rising surpluses in Japan, the NIEs and the ASEAN countries. China, despite its rising savings, has reduced its net surplus because of the enormous growth of its investment. So perhaps the ASEAN, the NIEs, or Japan, are responsible for moderating what was clearly excessive investment.

(Chart: US C/A &DEU and JAP) Before we end this tour du monde, however, let us look at one more chart. The last time the U.S. current account came out of a deep funk towards balance—in the early 1990s—growth in Germany and Japan was accelerating. But growth since then in these countries has been anemic. So perhaps we should hold Europe and Japan responsible for growing much more slowly than the United States.

The point that should be clear from all this is that the blame game is futile—as the children's ditty goes, when you point a finger at your neighbor, there are three more fingers pointing back at you. Global imbalances are a problem of global disequilibrium, and it is not very productive to point to one or the other endogenous variable—savings here or investment there—and pin the entire blame on it. Actions do matter but in this interconnected economy, it is near impossible to tell action from reaction. Far better to think about a coherent set of policies that will remedy the situation.

The charts suggest that we need greater savings in the United States, stronger growth in Europe and Japan, higher investment in the ASEAN, and greater consumption in China and the NIEs. Of course, for the sake of brevity, I have left out many other countries that can play a part including my hosts. But before I come to that, let me turn to how much exchange rates need to move to effect the adjustment in imbalances.

First, it is important to note that the goal is not to have the United States run a current account surplus but to lower the deficit to a medium-term sustainable level. Our macro-balance calculations show that the United States with its higher productivity growth and younger population can sustain a deficit in the medium term of between 2 and 3 percent of GDP without it exploding. This means the United States needs to cut today's current account deficit (of about 5.5 percent of GDP) by somewhere between one half and two thirds.

On the face of it, this would require quite a bit of change in real exchange rates—at least according to a very persuasive paper by my predecessor, Ken Rogoff, and Maurice Obstfeld. Their argument is as follows: since U.S. spending on traded goods that can be sold abroad (such as Boeings) is only about 30 percent of GDP, to reduce the current account deficit by 3.5 percent of GDP, spending on traded goods would need to fall by 10 percent. But the remaining spending is on non-traded goods, like haircuts and restaurant dinners, which cannot be bought by foreigners. If the production of these goods is not altered—and it will not be in the short run barring a major recession—the price of these non-traded goods have to fall relative to traded goods to induce the change in spending habits so that these goods are all bought. A fall in the price of non-traded goods is a real depreciation, so the dollar would have to depreciate substantially in real terms in order that traded goods become relatively more expensive and the transition of spending occurs without a reduction in employment in the United States.

But the size of the necessary depreciation depends importantly on the speed with which it takes place. The faster the exchange rate adjustment takes place, the larger it is likely to be for three reasons. First, exchange rate changes take time to pass through to domestic prices and a larger dollar depreciation is needed to achieve a given increase in the ratio of the price of U.S. tradeables to non-tradeables in the short-run than in the long-run. Second, exchange rate changes will affect production decisions over time. Given time, the extremely flexible and productive forces in the United States will move out of domestic oriented production into foreign oriented production. Technology, which is making more non-traded goods tradeable could also help. In other words, given time, supply will adjust to provide the traded goods that are more in demand and fewer non traded goods, so the real exchange rate will have to adjust less. And lastly, the faster the exchange rate movement the more likely it is to overshoot its medium-term equilibrium value.

In other words, the extent of exchange depreciation needed is not a given and depends very much on the time frame in which adjustment is allowed to play out. But will foreign investors remain patient and continue financing the U.S. current account deficit? (Chart: Overall US Assets) Recent alterations in the composition of capital flows may provide some clues to the answer. Overall, the bulk of U.S. assets sold to foreigners are still to the private sector. This may come as a surprise to some of you who have been led to believe by the financial press that the U.S. current account deficit is being financed by foreign central banks. The reality is that while the foreign official sector has increased its purchases, it still only amounts to about one-third of the total inflows into the United States. So where is the rest going if foreign central banks are putting in enough to nearly match the deficit? The answer is that it is coming out again as private US investors buy foreign assets. The counterpart of the massive inflows into the United States is the current account deficit and US investment abroad. One can say the United States deficit is being largely financed by foreign governments and US investment abroad is being largely matched by foreign private investment into the United States. Or one can say the United States deficit is more than financed by foreign private investors and US private investment abroad is being partly matched by foreign central bank investment into the United States. Both statements are equally true but somehow people emphasize the former and are more frightened by the seeming vulnerability of the United States. I would worry more about the latter.

For it suggests that critical to the continued orderly financing of the U.S. current account deficit is the attitude of the foreign private investor. (Chart: Private purchases) The private sector has altered the composition of the assets it buys in the last several years—purchasing far more bonds (mostly corporate and agency bonds) and eschewing equities and fixed direct investment. (Chart: US Treasury) Even though the foreign official sector has become a larger player, the vast majority of the official purchases have been in the form of long-term U.S. Treasury securities and to a lesser extent U.S. agency bonds. In fact, the official sector has recently surpassed the private sector as a net purchaser of long-term (greater than 2-year) Treasury securities. The reasons the official sector holds U.S. Treasuries is different than the private sector—reserve accumulation to forestall currency adjustments is one such reason. (Chart: Monthly Treasury) And from the evidence we have so far, they do not appear to vary their purchases of U.S. Treasuries in a systematic way with changes in the trade-weighted dollar. It is because profits are less of a motivation for foreign central banks than for private investors, and because by nature (and because of their large existing reserve holdings) they are unlikely to be disruptive, I worry less about central banks. In my view, it will be primarily the foreign private sector that will be key to the continued financing of the US current account deficit, and its decisions will largely be driven by expected returns.

It is time to recapitulate. A variety of policies, that we will come to shortly, have to be put in place to narrow global imbalances. Given time, these should do the job. But will investors provide that time. Perhaps! If they see a credible set of policies in place that will narrow imbalances, they will understand that the needed exchange depreciation will be relatively small, and they will be willing to hold U.S. financial assets. But if they doubt the resolve of policy makers, and they see that the current account deficit will become unsustainable at some point, investors will not stay around to see that day. Recognizing that the dollar will depreciate tremendously at that point, investors will sell dollar assets immediately. Paradoxically, this will force the adjustment: interest rates in the United States may spike up to attract back foreign investors and the exchange rate may depreciate more than necessary so that the anticipated appreciation will give investors an additional reason to return to the dollar. As I have argued, if adjustment is forced into the short run it will entail more depreciation, more dislocation, and slower growth than if the adjustment has time to play out.

The bottom line is that either policy makers will have to put in place credible adjustment policies or the market will force them to adjust under much less pleasant circumstances. So what are these policies?

(Slide: Fund policies) The Fund advice on the necessary policies has been consistent and is generally well known:

· Credible measures towards U.S. fiscal consolidation and other measures to boost US private savings;

· Structural reforms in the euro area and Japan, especially in the relatively inefficient domestic sectors, to boost domestic demand and growth; and

· Greater exchange rate flexibility and financial sector reform in emerging Asia. The first will also have the collateral benefit of allowing those countries more monetary control. The second can increase the level and improve the quality of their investments while reducing the need for savings.

While countries do seem to have accepted the need for these policies, one should not minimize either the difficulties or the urgency of implementing them. Note that if the measures were put in place or the intent to undertake them was credible, financial markets could be prepared to remain in a holding pattern, continuing to finance imbalances with the knowledge that something was being done. And indeed, nothing as yet suggests private investors have lost their appetite for U.S. assets. However there is a small but growing risk that they will.

One should also note that if exchange rates turn disorderly in the short run, monetary policy is still the first line of defense. Further significant appreciation of the euro will create conditions for the ECB to lower rates, while significant depreciation of the dollar should impel the Fed to raise rates sooner. Coordinated intervention could also be contemplated to reduce excessive volatility. But all these actions will be more effective if backed by a credible medium term plan.

This is why it may make sense to think about new ways to add credibility to policy intent. It will help to spell out in detail what is intended, as well as a timeframe wherever appropriate. But perhaps the strongest source of credibility will come from peer pressure. If the major countries can agree in a forum like that provided by the IMF, or in one of the regular meetings they have, to a common framework on what each one plans to do and when, there is greater hope that they will adhere to their undertaking because each one will be subject to collective monitoring. Clearly, countries will lose some policy independence, but none of the suggested policies are against a country's long run interests. Discretion and credibility, as this year's Nobel prize winners showed, do not go together. In this regard, the international cooperation on policies undertaken in the mid to late 1980s is instructive as it reinforced and aided the realignment of the dollar and correction of the U.S. current account. There was a collective and detailed commitment to domestic policy adjustment.

In many ways, the Fund's role as the primary body undertaking multilateral surveillance, is to not move with fads but to call things as we see them. When no one was worried about global imbalances because exchange markets were quiet, we were pointing out the dangers. But now that everyone is worrying, it is our responsibility to point out that there are reasonable ways out of this that do not involve a catastrophe. But they all require firm, credible, action on the part of our members. The blame game is a recipe for inaction, and unfortunately, also disaster. I am hopeful that our members see this as clearly as do the markets. Thank you.