The Hindu : Global economic imbalances

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Saturday, Jul 05, 2003

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Global economic imbalances

By C. Rammanohar Reddy

The basic challenge facing the global economy is that a world that for years has fed on the U.S. demand for goods and services needs to have other sources of demand.

THE IMMEDIATE outlook for the world economy does not at the moment look very bright. Growth in the advanced economies is sputtering. The threat of deflation is a live one; it has already spread to a number of countries. The recent reduction in the United States' interest rates to their lowest level in four decades was one attempt to prevent deflation from taking hold in the world's biggest economy. And the ongoing depreciation of the U.S. dollar appears likely to herald a major re-ordering of global financial flows and with that a forced shift to outside the U.S. of the sources of global economic growth.

A string of grim forecasts on the world economy have emanated from multilateral and national organisations in recent months. Over the past fortnight, the United Nations World Economic and Social Survey for 2003 speaks of apersistence of aslowdown in investment and trade growth and rising unemployment. The Bank of International Settlements, in its annual report for 2003, observes that during the past year, "economic disappointments, interrelated developments in the geopolitical, economic and financial spheres held back growth and led to great uncertainty about the future." The BIS too predicts that the weakening of the dollar may set off fundamental changes in the global economy. More ominously, the global banking institution warns that unless governments cope with protectionist pressures that could arise from possible deflation and intense global competition, the world could see a return to the 1930s kind of insular policies — rising import tariffs and the erection of non-tariff barriers which culminated in the global depression.

Such dire warnings appear out of place in the middle of 2003. The tides of many negative processes and uncertainties that have plagued the world economy appear to have ebbed, or even receded altogether. The recession that followed the bursting of the stock market bubble in 2000 was a shallow one and growth in the advanced economies quickly turned positive. The world economy seems to have digested the worst of the excesses of the so-called "new economy" of the late 1990s and new investment is expected to pick up soon in the advanced countries. Stock market prices have been rising once again on the world markets. The economic fallout of the terrorist attacks in the U.S. in 2001 and of the war on Afghanistan was less serious than expected. More recently, there were many fears about the immediate and long-term economic impact of the invasion of Iraq on the global economy. Those uncertainties as well quickly dissipated. Why then are there continued fears about the prospects of faster global economic growth?

The economic issues that the recent forecasts have addressed are not of a short-term nature. Global savings imbalances which have made the rest of the world "save" on behalf of the U.S., the locational concentration of the engine of global economic growth in the U.S and the creeping forces of deflation in Japan, China and now Germany are all deep-rooted issues and problems that cannot easily and quickly be tackled. The resolution of these issues will have ripple effects that will, in the interim, affect all of the world's economies, including the developing countries which remain on the periphery of the global economy.

What are the "deep-rooted economic forces at work", that the BIS sees as responsible for the repeated disappointments of a revival of global growth?

The first and foremost factor, according to the Basel-based institution, are the imbalances in global financial flows, in which the low savings rate of the U.S. has an important role to play. It is often argued that the major structural problems in the global economy today are to be found in the European Union and Japan. (From the perspective of the global economy, the problems of the developing countries are unfortunately not considered very important since the latter have a low weight in the global gross domestic product.)

Yet, the fault lines perhaps run deeper in the U.S. The excesses of the "new economy", for instance, were produced in the U.S. and the world economy is still dealing with the after-effects of over-investment and exaggerated expectations.

The irrational exuberance of the late 1990s drove a consumer boom in the U.S. that was financed by borrowings. Households borrowed against inflated share prices and from banks as well to finance their consumption spree.

One reason why the post-2000 recession was a short and shallow one was that the consumer demand remained strong. The private sector cut back on its investments and brought inventories down, but households continued spending. The consumption boom was sustained partly by low finance (the generous terms for automobile purchases in 2002 and 2003 are an example) and partly by borrowing against yet another asset whose prices were rising — residential houses.

The result of the debt-financed spending of U.S. households is that the burden of the borrowings on personal incomes has been rising. According to the BIS estimates, the debt to household income ratio has now crossed 100 per cent in the U.S., and debt servicing costs have reduced personal income by 14 per cent, "appreciably more than a decade earlier".

At the macro-level, the low savings rate and large debt burden of households get reflected in a very large current account deficit of the balance of payments of the U.S. and huge capital flows (borrowing) from the rest of the world.

The current account deficit of the U.S. crossed 5 per cent of GDP in 2002. This current deficit has been financed by the rest of the world. Net liabilities in the hands of foreigners is now, according to BIS figures, equivalent to 25 per cent of U.S. GDP.

A current account deficit reflects an excess of imports over exports; so a large deficit in the U.S. means that import demand has been substantial. This is good for the rest of the world, especially the Asian countries exporting to the U.S. But a household spending spree driven by borrowings, a large current account deficit and correspondingly large capital inflows cannot be sustained forever. Sooner or later, a correction has to take place.

Such a correction has begun and if it is carried through, the effects will be felt across the world. As the return on U.S. assets has declined, the incentive to invest in that country has begun to wane. The BIS observes that this has led to a small but perceptible slowdown of capital flows to the U.S. This, in turn, has initiated a gradual decline in the value of the dollar. If the process continues, this adjustment of the dollar will have many implications. A decline in the value of the dollar will, of course, reduce the U.S. current account deficit by boosting exports and curbing import growth.

But more important, and this is the second impact, the slowdown in the growth of imports into the U.S. means trouble for Japan, China and the South-East Asian countries, all of which depend heavily on exports to the U.S. To make matters more difficult, these countries will have to start competing with more price-competitive exports from the U.S. The third impact of a decline in the value of the dollar is that it can feed on itself. The U.N. World Economic and Social Survey for 2003 argues that the dollar's fall could set off a vicious circle in financial markets. A cheaper dollar means the returns for foreign investors (in their currencies) will fall. This may make it less attractive for them to lend to the U.S. to finance the current account deficit, which in turn would push the dollar down further and so on. How orderly the transition process will be to a lower value for the dollar will depend on the speed of adjustment of the current account deficit for the U.S.

The basic challenge facing the global economy then is that a world that for years has fed on the U.S. demand for goods and services needs to have other sources of demand. Unfortunately, there is now no other engine of export demand that can replace the U.S. Both the E.U. and Japan, large economies that could have offset the dip in import demand for the U.S., are in difficulties of their own kind. They cannot therefore show the same appetite for East and South-East Asian exports that the U.S. did. This, in effect, means that domestic demand more than exports will have to drive the global economy. If that happens, it will be quite a transformation of the globalised world.

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