Global imbalances as constraints to the economic recovery in developed economies.

1. Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied Economics V University of the Basque Country UPV/EHU Conference “International Economic Policies, Governance and the New Economics” The Cambridge Trust for New Thinking in Economics Cambridge, Thursday 12 April 2012

2. Do Current Account Imbalances (CAIs) matter? • CAIs involve financial flows. High CAIs involve high net financial (in/out)flows, and the latter may be a source of problems (via interest rates, exchange rates…) • CA deficits may be generated by fiscal deficits, leading to the possibility of twin crises (BoP and fiscal crisis) • Permanent CA deficits lead to the accumulation of external debt. Problems in case of sudden stops • CA imbalances involves: • a trade deficit that constrains the economic activity • a trade surplus that involves an export-led growth strategy, whose long-term sustainability depends on the economic activity in foreign partners

3. Can CA Imbalances be a problem for the World economy? Current Account imbalances can be a source of systemic risks depending on the: • Size of the imbalances • Trend (conjunctural or structural nature) • Concentration in a low/high number of countries • Extension of the phenomenon: number of countries with high CA imbalances

4. Size of Current Account Imbalances

5. The size of the CAI is measured as the average of the sums of the absolute values of the CA deficits and surpluses as percentage of the World GDP

6. The evolution of the current account imbalances shows a clear rising trend: • 1980-1999: 1.26 per cent World GDP • 2000-2011: 2.21 per cent World GDP Is this evolution the result of a cyclical pattern, a long-term smooth trend, or the result of a structural break in the framework of foreign trade relations?

7. Trend of Current Account Imbalances To test this hypothesis we have applied a structural time series analysis to the behaviour of the size of current account imbalances in the world economy. The model tested is: where μ is the level, ψ is the cycle, and ω an intervention (dummy variable) The stochastic trend (level+slope) component is specified as: We include 3 interventions variables : years 2001 and 2009 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the level in year 2000 (taking the value 1 since 2000)

8. The model shows a significant structural break (equivalent to 0.22 p.p. world GDP) in the size of CA imbalances that took place in 2000

10. The models shows that since 2000 the size of current account imbalances has a rising trend. This involves that the problems (directly and/or indirectly) generated by these imbalances are more intense than in the past

11. Concentration of world disequilibria in the current account balance

14. Extension of CA imbalances: number of countries with high imbalances

16. Reasons of Current Account Imbalances 1. Real versus financial causes: • Based on current account (CA) balance: disequilibria in BC lead to disequilibria in BK • (S-I)  (X-M) • (X-M)  (S-I) • Based on capital account balance (Bracke et al, 2008): disequilibria in BK lead to disequilibria in BC: • Asian crisis • Underdeveloped financial sectors in Emerging Market Economies

17. 2. U.S. versus rest of the world (EMEs) origins: • USA: • Rise of US productivity growth (Hunt and Rebucci, 2005; Engel and Rogers, 2006; Bracke et al, 2008; Kroszner, 2008) • Increases in private consumption and declines in saving rate (Bernanke, 2005; Kroszner, 2008) • Attractiveness of US financial system (Bernanke, 2005) • Dollar liquidity and low US policy rates since 2001(Bibow, 2008-9) • Special international status of US dollar (Bernanke, 2005) • Rise of US household consumption not offset by declines in the spending of other sectors (Gruber and Kamin, 2009)

18. Rest of the world (EMEs, aged developed economies, oil exporters) • Global savings glut - investment draught (Bernanke, 2005, 2007; Rajan, 2006) • Rise in Chinese saving rate • Chinese public savings glut (Hermann and Winkler, 2009) • Weakness of financial systems in developing economies (Bracke et al, 2008, Kroszner, 2008, Hermann and Winkler, 2009) • Financial crises in EMEs lead to build up foreign exchange reserves as a buffer against capital outflows (Aizenmann and Lee, 2007; Aizenmann and Sun, 2009; Bernanke, 2005; Gruber and Kamin, 2009; Hermann and Winkler, 2009; Lee, 2009; Cova et al, 2009) • Sharp in oil prices (Gruber and Kamin, 2009) • Domestic demand stagnation in some developed countries (Bibow, 2008-9) • Ageing in developed economies

19. China’s policies (Corden, 2009): exchange rate policy, build-up of foreign exchange reserves as a form of self-protection (parking theory), high household and corporations savings • Massive excess supply of labor in Asia (Dooley et al, 2009) • Financial liberalization in Emerging Asian Countries (Dooley et al, 2004; Chadha, 2006; Caballero et al, 2006) • Financial liberalization plus higher productivity growth in the rest of the world (Chakraborty and Dekle, 2009) • Productivity slowdown in the nontradeable sector of emerging Asia (Cova et al, 2009)

20. 3. Mixed Origin: • Bretton Woods II (Dooley et al, 2003): symbiosis of interest among US and surplus developing countries: Developing countries base their development in exporting to US; the US finance its CA deficit by selling safe financial assets, which provide the collateral for inward FDI in developing countries • Differences in financial development: spending in the US is more responsive to lower costs and higher availability of credit stemming from the global saving glut than other advanced economies (“spending response” hypothesis: Gruber and Kamin, 2009) • Differences in the productivity growth: higher TFP growth in the US nontradable sector and higher TFP growth in the tradable sector of the rest of the world (Obstfeld and Rogoff, 2007; Cova et al 2008)

21. All these hypothesis have problems: • The assumption of a direct relationship between financial and current account flows • They can not explain why the desire/objective of some countries to generate a surplus in their current accounts (accumulation of foreign reserves) can effectively be materialized • They can not explain why during the last decade, the generation and the rising size of current account imbalance is a generalized (and long-lasting) phenomenon, and why the increase in the number of deficit countries is higher than that of surplus economies

22. The size and the evolution of these imbalances (and that of EU with China) is explained by a process of worldwide relocation of production of tradeable goods: a change in the global value added chain. This process has been fuelled by FDI inflows from developed economies to emerging economies Consequently, it is a structural-nature process that cannot be solved with short-term measures like exchange rate adjustments or macroeconomic (fiscal-monetary) policies

24. Structural break in the series of FDI flows We have applied a structural time series analysis to the behaviour of the FDI flows in the world economy. The model tested is: We include 3 interventions variables : years 1999 and 2000 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the level in year 1998 (taking the value 1 since then)

25. The results show a rising trend in the FDI flows and a structural break in 1998, equivalent to a permanent increase of 0.6 per cent of the world GDP

27. Structural break in the series of FDI flows We have applied a structural time series analysis to the behaviour of the FDI flows in the world economy. The model tested is: We include 4 interventions variables : years 2002, 2005 and 2008 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the slope in year 1997 (taking the value 1 since then)

28. The results show a rising trend in the FDI stock and a structural break in 1997, equivalent to a permanent increase of 0.9 per cent of the world GDP

30. How to solve current account imbalances Traditional solutions to solve a current account imbalance are: • Demand-side policies: (T+G) + (S-I)=(X-M) • Current account deficits: restrictive fiscal-monetary policies • Current account surpluses: expansionary fiscal-monetary policies • Exchange rate policy: • Current account deficits: depreciation • Current account surpluses: appreciation

31. In the case of demand-side policies: • the reduction of CA deficits involves a negative impact on economic activity • the reduction of CA surpluses assumes: • that surplus country will increase the demand of goods-services produced abroad, • that domestic agents absorb some of the production formerly exported • that foreign partners will be able to generate the (higher) supply of these goods • that there is a foreign supply of these goods Option b may lead to higher prices of goods exported by the surplus country. If foreign partners do not increase the production of these goods (substituting imports by domestic production) and the demand of imports is highly inelastic, import prices in these deficit countries will rise, increasing the CA deficit

32. In the case of exchange rate policy: • The impact of changes in the exchange rate depends on the elasticity of the demands of imports and exports • Highly inelastic demand of imported goods lead to a deterioration of CA balances if the currency depreciates • A low sustituibility between domestic goods and imported goods involves very high depreciation of the domestic currency • The impact on trade balances of changes in the real exchange rate depends on the level of intra-industrial trade: in countries with low intra-industrial trade, the depreciation of the RER can deteriorate the trade balance (Kharroubi, 2011) • A change in the exchange rate of a single currency might not affect the CA balance of a thirs partner, if the exports of the first country compete with other countries whose currencies do not change • Empirical analyses (Altuzarra, Ferreiro and Serrano, 2010), using cointegration and VCM, show that a depreciation of the euro improves the trade balance with China, but a depreciation of the dollar deteriorates the USA trade balance with China

33. Conclusions • Current Account Imbalances are a source of potential (systemic) risks: • Problems coming from the related financial flows • Constraints to the economic activity in deficit countries • Current account imbalances have a structural nature: • The size of CAI has increased in the last decade • The number of countries with high CAI has increased • CAI is concentrated in a low number of economies • Current Account Imbalances are explained by a process of worldwide relocation of production of tradeable goods (fuelled by FDI flows from developed economies): is a structural-nature process that cannot be solved with short-term measures like exchange rate adjustments or macroeconomic (fiscal-monetary) policies • Adjustment of CA deficit involves a change in the productive structure (size and composition of aggregate supply) of the deficit country: need of supply-side policies (e.g., industrial policies, policies fostering FDI inflows...)