Global Recession Risk: Dollar Devaluation and the World Economy

The Global Recession Risk Dollar Devaluation and the World Economy

Carlos M. Peláez and Carlos A. Peláez

The Global Recession Risk

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The Global Recession Risk Dollar Devaluation and the World Economy Carlos M. Peláez and Carlos A. Peláez

© Carlos M. Pela´ez and Carlos A. Pela´ez 2007 Preface © Antonio Delfim Netto 2007 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The authors have asserted their rights to be identified as the authors of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2007 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N. Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN-13: 978–0–230–52150–6 hardback ISBN-10: 0–230–52150–9 hardback This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. A catalogue record for this book is available from the Library of Congress. 10 16

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To Magnolia and Penelope

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Contents List of Tables

ix

List of Abbreviations

xi

Acknowledgments

xiv

Preface Antonio Delfim Netto

xvi

Leading Essay: Lessons from Adjustment of the Current Account Richard T. McCormack

1

Introduction, Scope and Content

8

1 Policy Contributions The United States current account Risks Savings and investment Financial flows

20 20 21 27 38

2 China in Need of a New Paradigm Introduction The two Chinese economies The Chinese exchange rate The need of a new paradigm

56 56 59 66 78

3 Japan after Deflation Summary The lost decade Fear of deflation in Japan, China, Europe and the Federal Reserve Board Monetary policy Exchange rate intervention Structural reform Conclusion

81 81 82

vii

83 95 107 109 111

viii Contents

4 The Euro Area Summary The decline of Germany Monetary policy Fiscal imbalance Productivity and structural reform External balance

116 116 117 119 127 135 144

5 Currency Crashes Sudden stops The vulnerabilities of Mexico Original sin and debt intolerance The balance sheet approach Appendix: Balance sheet effects in practice

147 147 154 162 174 178

6 The Restrictions of Policy of the United States The budget and current account deficits The economic and financial fundamentals of the United States The limitations of policy Policy guidelines

188 188

Conclusion

218

Appendix

230

Notes

232

Bibliography

234

Index

255

202 212 215

List of Tables 1.1 1.2 1.3 2.1 2.2 2.3 2.4 3.1 3.2 3.3 3.4 3.5 3.6 4.1 4.2 4.3 4.4 4.5 4.6 4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15

US, current account, NIIP, fiscal balance, debt and nominal GDP Summary of results by Croke et al. (2005) Results of Freund and Warnock (2005) Indicators of the Chinese economy China, year-on-year growth rates, June 2006 China, growth of selected industry and installed capacity year-on-year, June 2006 Growth of China since 1979 Japan, asset prices, interest rates and M2 Japan, GDP, prices, unemployment and government bond Japan, prices, stock market, call rate and industry Japan, short-term economic indicators Bank of Japan, forecasts of the majority of policy board members % year on year change Bank of Japan, date and decision on guideline for money market operations GDP per capita, Purchasing Power Parity (PPP) dollars of 2002 GDP per employed person, PPP dollars of 2002 Average yearly rates of growth, % per year Rates of unemployment in the euro area Indicators of the euro area Yield of 10-year bonds and stock market index Interest rates of the ECB EIA forecasts of oil and derivatives Petroleum capacity of the Gulf Coast of the United States Deficit and debt, % of GDP Deficits as percent of GDP Output per hour in manufacturing, yearly % change Average yearly rates of change of productivity and unit labor costs European Union, integrated guidelines Euro area current account and trade, EUR billion ix

20 39 41 62 65 66 80 84 90 96 97 99 114 118 118 119 120 120 120 122 124 126 127 131 135 136 138 144

x List of Tables

4.16 Germany, France and Italy, current account and fiscal balance 5.1 Mexico, economic indicators 5.2 Brazil, average growth rates of money, income and prices 5.3 Brazil, CAD, GDP growth and CPI 5.4 Brazil, GDP growth, CPI, CAD, trade, debt, FDI, exchange rate and reserves 5.5 Changes in balance sheet vulnerabilities of 25 countries 5.6 Brazil, interest rates, devaluation and inflation 1986–87 5.7 Computation of positions of dollar book 6.1 United States indicators 6.2 Impact of the change of the dollar on the NIIP of the United States 6.3 External and internal balance, net debt and GDP growth 6.4 Fed funds rate, 30-year treasury, 30-year mortgage and CPI 6.5 United States fiscal balance C.1 United States 30-year mortgage rate C.2 Global current account, trade balance, savings and investment C.3 USA, exports, imports and trade balance A United States, current account and nominal GDP

145 157 167 170 172 176 185 186 193 201 204 207 215 224 227 228 230

List of Abbreviations ADM AMLO BCBS BIS BLS BOJ BOM BSA CAD CAPM CAR CBO CD CDI CNY CMHPI CPI CSIS DI DLD ECB EDP EIA EMBI EMU ERM ETF EU EUR FDI FOMC FRB FX swap GEM HICP IEA

Sales and repurchase agreement cost of CDs Andrés Manuel López Obrador Basel Committee on Banking Supervision Bank for International Settlements Bureau of Labor Statistics Bank of Japan Bank of Mexico Balance sheet approach Current account deficit Capital asset pricing model Current account reversals Congressional Budget Office Certificate of deposit Certificate of inter-financial institution deposit Chinese yuan renminbi Conventional Mortgage Home Price Index Consumer Price Index Center for Strategic and International Studies Debt intolerance Dollar liability dollarization European Central Bank Excessive deficit procedure Energy Information Administration Emerging market bond index European Monetary Union Exchange Rate Mechanism Exchange traded funds European Union Euro Foreign direct investment Federal Open Market Committee Federal Reserve Bank Foreign exchange swap Global Economy Model Harmonized Index of Consumer Prices International Energy Agency xi

xii List of Abbreviations

IFA IFI IIE IIR IMF IMFC IPO IRCA JGB JPY LAC LBC LDP LTCM NAFTA NAIRU NFA NIE NIIP NIR NPL MOF MTO OECD OPEC OLS OS OTN PAN PBC PPP PRC PRD PRI PSBR PT REIT SGP SME SOE SRP

International Financial Architecture International Financial Institutions Institute for International Economics Institutional Investor Ratings International Monetary Fund International Monetary and Financial Committee Initial Public Offering Immigration Reform and Control Act of 1986 Japanese government bond Japanese yen Latin American and Caribbean Central bank bill (of Brazil) Liberal Democratic Party Long Term Capital Management North American Free Trade Agreement Non-inflation accelerating rate of unemployment Net financial assets Newly industrialized economies Net international investment position Net international reserves Non-performing loans Ministry of Finance of Japan Medium-term objectives Organization for Economic Co-operation and Development Organization of Petroleum Exporting Countries Ordinary least squares Original sin Obligation of the National Treasury of Brazil Partido Acción Nacional People’s Bank of China Purchasing Power Parity People’s Republic of China Partido de la Revolución Democrática Partido Revolucionario Institucional Public sector borrowing requirements Partido dos Trabalhadores Real estate investment trust Stability and Growth Pact Small and medium enterprises State-owned enterprises Sale and repurchase agreement

List of Abbreviations xiii

SS TFP TOPIX WTI WTO

Sudden stops Total factor productivity Tokyo Stock Price Index West Texas Intermediate World Trade Organization

Acknowledgments This project originated ten years ago in a study of globalization (Fortes and Peláez (1997)). Subsequently, we expanded this initial effort in another book (Peláez and Peláez (1999)). At that early stage we benefited from the advice of Senator Heráclito Fortes, of the National Congress of Brazil, on the need to reconcile policy proposals with political realities. The third book, International Financial Architecture (Peláez and Peláez (2005)), began as an update of the chapter on the international financial system. Professor Paulo Yokota and Ed Mendez helped us with advice. There is brief discussion in that volume of the growing concern with the external imbalance of the United States (Peláez and Peláez (2005, li)). At a meeting in Washington, DC, Ambassador Richard T. McCormack shared with us the interest in policies of adjustment of the current account deficit of the US that would not have adverse effects on the world economy. Ambassador McCormack was engaged in a broader project on global imbalances at the Center for Strategic and International Studies (CSIS). We completed a preliminary survey of the literature on global imbalances in February 2005. However, we realized that an adequate treatment of the subject required a longer monograph. This volume is the result of this effort. The doctrine of shared responsibility of the Group of Seven (G7) is the official solution to the adjustment of global imbalances. While this doctrine is elegant in terms of its policy conception, there are numerous political and technical hurdles to its implementation. The risk for the world economy is that a fire sale of dollar debt may cause disorderly dollar devaluation, inflation and a rise in interest rates that could provoke a recession not only in the US but worldwide. However, there is no theory with predictive value on the timing and effects of such disorderly dollar devaluation. Professor Antonio Delfim Netto has had wide experience in dealing with external and internal imbalances during a long career of academic and public service. He kindly wrote the preface to this volume. We are also extremely grateful to Ambassador McCormack for suggesting the need of this monograph, for many ideas during its research and writing and for the leading essay to this volume. xiv

Acknowledgments xv

An anonymous reviewer of Palgrave provided very valuable suggestions that we used to revise the manuscript. Amanda Hamilton, Economics Publisher of Palgrave Macmillan, provided suggestions that dramatically improved the content and style of this book. Alec Dubber, Editorial Assistant of Economics at Palgrave, competently steered the manuscript for publication and we thank Ian Evans for the production of the volume. Shirley Tan of EXPO Holdings improved significantly the style and eliminated errors. We are again extremely grateful to Palgrave Macmillan for an exceptionally pleasant publication experience. As in all our work, we have a deep debt of gratitude to Clay and Rondo E. Cameron for their inspiration to engage in scholarship across the world. Although we recognize these many debts, we emphasize that we alone are responsible for all errors and opinions that remain. Carlos M. Peláez and Carlos A. Peláez Philadelphia, November 2006

Preface The Risks of the World Economy Antonio Delfim Netto It is convenient to consider the dimensions, origins and nature of the risks to the world economy from global external imbalances to analyze available policies. The dimensions and rate of change of these imbalances constitute the major reason for concern. The absolute magnitude of the imbalances suggests the possibility of risks to global stability. The current account deficit of the United States jumped from $140 billion in 1997, or 1.7 percent of GDP, to $415 billion in 2000, or 4.3 percent of GDP, and $791 billion in 2005, or 6.4 percent of GDP. A common forecast is 6.6 percent of GDP in 2006 and about $1 trillion in 2007. The deficit of the US is absorbing three-quarters of the world’s surpluses. Another measure of magnitude is the level of more than $1 trillion of reserves of China. Conventional economics would suggest that China would be a net borrower from other countries to finance domestic opportunities for investment. Moreover, the sterilization of such a large reserve inflow fuels loans to domestic investment that may not be sound. To be sure, the concern should not be solely on China but on the general undervaluation of currencies in East Asia. There is continuing debate among economists and central bankers on the origins of the US external deficit. The external accounts shifted to deficit in 1997–2000, when there were fiscal surpluses. Some economists argue that those deficits were “benign” because the US borrowed abroad to finance domestic opportunities with higher relative returns. According to this view the current external deficits merely finance consumption because of their co-existence with fiscal deficits. Another strand of thought attributes the US external deficit to a world savings glut. Several combined events, such as the rise in productivity in the US relative to other industrial countries after 1995, financial globalization and the fear caused by the Asian crisis of 1997, caused savings in developing countries, such as China, to exceed investment. The US became financially attractive to place those savings as precaution against risks. xvi

Preface xvii

No matter what the preferred current of thought, there was a second round of worsening of the external deficit of the US. Oil prices increased to their highest historical levels, causing further deterioration of the trade account of the US. Moreover, interest rates had been fixed in 2002–03 at their lowest levels in four decades. Currently, all three major central banks in the United States, European Monetary Union (EMU) and Japan are increasing interest rates. However, the United States led other countries in the increases of its central bank policy rate. It is difficult to analyze the external accounts of the US and its danger to the world economy because the dollar is a reserve currency for most countries. Thus, a depreciation of the dollar increases the market value of net US foreign assets because assets increase in dollar value while most liabilities, which are in dollars, remain unchanged. Moreover, the US is similar to a “venture capitalist,” receiving the premium of investment in equities relative to payment of low rates on its fixed income securities. However, there is still valid concern that there may be a point where investors in dollars may require a much higher interest rate to hold dollar debt. Expectations of dollar devaluation may adversely influence the allocation of assets to dollar debt. Diversification of investment portfolios in other currencies could result in “disorderly” devaluation of the dollar. This view has now been incorporated in the doctrine of “shared responsibility” of the G7 and of the International Monetary Fund (IMF). According to this doctrine, the US would have to increase savings relative to investment; Japan and Europe would have to increase domestic demand and implement structural reforms; oil-producing countries would have to invest more at home; and, some countries in emerging Asia would have to revalue their currencies. In our time, we have seen failure of less ambitious cooperation in international policies. The concern is that there may be a global recession with or without these policies. As typical, economic predictions mostly fail to materialize or the predicted event occurs because of other reasons. The authors of this volume have provided an exhaustive analytical survey of research on all issues and currents of thought on the risks of global imbalances. Readers can form their own opinions because of the impartial nature of the text. A significant difference in this volume is that it considers the required adjustment policies in the key regions— the US, European Union (EU), China and Japan. An extra chapter treats the major aspects of the theory and experience with currency crashes.

xviii Preface

Thus, the book provides a comprehensive analysis of the impact of potential dollar devaluation on the world economy. It complements the risk analysis of the international financial system in their successful earlier scholarly work on International Financial Architecture. Antonio Delfim Netto is Federal Representative (PMDB-SP) in the National Congress of Brazil. He was Chief Minister of the Secretariat of Planning of the Presidency of the Republic of Brazil (1979–85), Minister of Agriculture (1979), Minister of Finance (1967–74) and Secretary of Finance of the State of São Paulo. He is Professor Emeritus of the Faculty of Economics and Management of the University of São Paulo. He has published, in Brazil and worldwide, numerous books and essays in professional journals and articles.

Leading Essay: Lessons from Adjustment of the Current Account Richard T. McCormack

The research for this volume originated during discussions in Washington, DC, in which I asked the authors to analyze competing proposals to adjust the current account deficit of the United States. This was part of a major project I led at the CSIS, involving Senator Chuck Hagel, Professor Raghuram G. Rajan, who is the Chief Economist of the International Monetary Fund, and others. Adjusting external imbalances is the current most important and potentially dangerous issue in world finance. We had the opportunity to discuss these issues during the project, research and writing of this volume. The most recent adjustment of the US current account deficit occurred during the second half of the 1980s. Between 1985 and 1990, US exports increased by 85.2 percent while imports increased by 49.9 percent. The current account deficit declined from around 3 percent of GDP to 1.4 percent in 1990 while the economy maintained growth at capacity in manufacturing. Moreover, there was international cooperation similar to that envisioned in the doctrine of “shared responsibility” sanctioned during the April 2006 meeting of finance ministers and monetary authorities of the G7. It is highly instructive to explore the policies in the 1980s to derive lessons for the current adjustment challenge. Because of the strong dollar in the first Reagan Administration, which had roots in the global economic weakness of the time and very high US interest rates, America’s manufacturing companies faced increasingly serious pressure from foreign competitors, particularly from Japan. Whole industrial regions in America became known as the Rust Belt, as steel and auto plants, and related service industries, began closing in the face of foreign competition. As America’s current account deficit and unemployment began to mount, so too did political pressures from Congress to address the 1

2 The Global Recession Risk

perceived causes. There was a tremendous battle in the Administration over what to do. The University of Chicago group, which included Secretary of State Shultz, felt that the market should be allowed to resolve any problems. One heard such comments as: “Why should we complain if foreigners are willing to give us real goods, very cheaply, and are willing to accept pieces of paper in return?” Congress, on the other hand, felt that foreign trade had become a rigged game in many parts of the world, driven by the mercantilism of export-led economies. There was a perception in Congress that Japan and Others had erected a web of non-tariff barriers screening the Japanese economy from imports, while our economy was relatively open. The Defense Department worried about the loss of the American industrial and high tech base that supported potential war-fighting capabilities. President Reagan instinctively supported the idea of free trade, but he was also a realist. Gradually he launched a more aggressive program to stabilize the US trade deficit and the political and economic problems that flowed from it. He began with a voluntary restraint agreement on automobiles with Japan. After the elections in 1984, President Reagan launched a broader effort to reverse the United States current account deficit, which at that time stood at 3 percent of US GDP, about $90 billion annually. The President decided that the strong dollar had become a liability. He directed the Secretary of the Treasury to correct the problem. Markets were aware of the soaring US trade deficits and of the administration’s concerns. They preemptively began to sell dollars. Secretary Baker then met with his counterparts from the United States, Japan, the United Kingdom, France, and Germany (G5) at the Plaza Hotel in New York and engineered an agreement that resulted in a steady further weakening of the dollar against the currencies of the major surplus countries, such as Japan. This cooperation was not purely voluntary. It was absolutely clear to our trading partners that if they did not cooperate in addressing the US trade deficit, Congress would impose its own solutions. The administration and Congress began applying pressure on countries like Japan to relocate auto plants in the United States. American economic authorities adopted a number of other microeconomic policies to assist specific sectors of the US industrial base. Throughout this period, there were steady efforts by the finance ministers of the G5 to intervene in markets to stabilize the currencies at a rate deemed appropriate by the G5 decision makers. Markets, however,

Leading Essay: Lessons from Adjustment of the Current Account 3

did not cooperate. Instead, the dollar plummeted against the European and Japanese currencies. The G5 then decided that the dollar weakening had gone too far, since it threatened to put American markets out of the reach of many overseas exporters, beyond the levels wished by all parties. Secretary Baker was then persuaded to support a coordinated effort by central banks to link G5 monetary policy to targeted exchange rates. The theory was that if a country’s currency strengthened excessively, monetary policy would be more expansive. If it fell below the level set by the G5 target zones, central bank monetary policy would then be tightened. This was the unpublicized part of the Louvre Agreement. There was a conflict in the Louvre Agreement. While it did accomplish its objective of moderating the dollar’s earlier rate of decline, it also resulted in US monetary policy being made on the basis of the 10 percent of the American economy involved in international trade. It constrained the larger 90 percent of the American economy that was not involved in international trade by an excessively tight monetary policy. This conflict alarmed a number of people, including Beryl Sprinkel, then Chairman of the President’s Council of Economic Advisors. Sprinkel, my colleague in the Reagan administration, was also my frequent fishing companion during his time in Washington. Throughout the spring and summer of 1987 he grew more and more upset about what he predicted would happen to US financial markets if monetary policy remained locked into the Louvre Agreement. Finally, unable to convince his colleagues of his concerns, Sprinkel decided to resign. The day after his retirement party at the White House in October of 1987, the President invited him to make his case in the oval office, with the Administration’s key decision makers attending, including Federal Reserve Bank (FRB) chairman Alan Greenspan. Sprinkel predicted a crash of the stock market unless the Louvre Agreement was abandoned and a more accommodative monetary policy launched. That was on a Friday. That night he called me to say that his efforts had failed. The largest one day decline in the stock market since 1929 occurred the following Monday. The President insisted that Sprinkel rescind his resignation and elevated him into the Cabinet. The Louvre Agreement was immediately abandoned and frantic efforts were launched throughout the G5 to recover financial markets. An accompanying part of the Administration’s strategy to improve America’s current account deficit encouraged other countries with large trade surpluses to open their markets and stimulate more domestic-led

4 The Global Recession Risk

demand. The two Miyazawa Reports in Japan reinforced this effort. This involved substantial expansion of Japanese monetary policy, which produced a stock market and real estate asset inflation. It temporarily increased Japanese purchasing power at home and abroad. In the 1990s, Japan experienced a crash in stock and land prices that eventually erased literally tens of trillions of dollars of wealth. Japan is still living with the legacy of the bubble era and its deflationary and debt aftermath. Because of the lack of sustainable domestic demand, due in part to structural problems, Japan depends permanently on export-led growth and on a huge trade surplus. Like China, Japan intervenes in currency markets directly through the central banks and indirectly through administrative guidance to other cash-rich parts of the economy. I have analyzed in detail elsewhere the vulnerabilities that threaten the international economy and operative lessons for policy (McCormack (2005a), xliv–vlii). The past experience of the United States—in particular in the Reagan administration—suggests how to adjust the current account deficit with benign effects. Policy efforts should focus on adjustment of the global imbalances without threatening world prosperity. The greater the imbalances, the harder this will be to achieve. The following are important lessons of adjustment of the current account. 1. Regardless of the mistakes made by the G5 in the late 1980s, the overall American objective of stabilizing the US current account deterioration was successful. The US current account deficit remained less than 2 percent of GDP for more than ten years after the Plaza Agreement. It was only with the onset of the Asian financial crisis of 1997 that monetary policy asset bubbles and changes occurred, leading to an accelerating collapse of the US current account position. 2. Attempts to fine-tune the Plaza Agreement with its Louvre Agreement successor were obvious failures. There are limits to the ability of governments to manage international currency ratios. In the absence of strong underlying supportive policies that are marketbased, not only do such efforts ultimately fail, but they often bring with them disastrous unintended consequences. 3. It does not take a central bank very long to create asset inflation, as the Japanese experience richly demonstrates, but the long-term consequences of an asset bubble can weaken an economy for many years.

Leading Essay: Lessons from Adjustment of the Current Account 5

4. The Plaza Agreement could not have been achieved in the face of resistance by export-led countries without the threat of protectionist legislation from Congress. It is also true that earlier efforts of the United States to address its current account problem in the early 1970s were also accomplished by unilateral protectionist pressures. However much congressional pressure on trade and currency policy is deplored, it remains an essential ingredient of any program to modify on a timely and orderly basis the currency policies of trade surplus countries in Asia and elsewhere. Protectionist pressures in democracies, however, can spin out of control if the public impression deepens that there is no other solution to a massive and threatening current accounts problem. Any future recession would multiply such risks. 5. The multi trillion dollar losses on financial markets following the 1987 crash dwarfed the earlier $90 billion current account problem that the Reagan Administration was trying to fine tune. Today’s US current account problem is more than twice the size of the Reagan era deficits as a percentage of GDP. We are approaching an annual trade deficit that will soon explode toward $1 trillion a year, with no end in sight. Each $1 trillion of debt accumulated by our trade deficits will require a long-term interest service charge of 5 percent or so, a $50 billion dollar annual service charge. These debt service charges will be on top of our future import bill, which means that in the future we will have to export even more goods and services to pay for them. 6. The United States has an absolute future requirement to sell more goods and services abroad, buy less of them from overseas suppliers, or some combination of the two. The challenge we face in the US is to create the market-based conditions needed to produce more tradable goods and services for domestic and global markets. This will require millions of investment decisions at all levels of the economy and strategies for increasing sustainable domestic demand in a number of under performing and over saving economies elsewhere in the world. It will also require a major dollar devaluation, as in 1985 and 1971. 7. In accomplishing these objectives, we need to learn from the successes of the past, namely the Plaza Agreement and avoid blunders like the Louvre Agreement and the Japanese bubble. We also need to remember that the global economy today contains a number of potential fragilities. America must not only address an

6 The Global Recession Risk

unsustainable current account problem, but also engineer a soft landing to the double-barreled asset inflation of recent years. Europe faces a crisis of leadership and high unemployment in major countries. Japan’s public debt exceeds 180 percent of GDP, much more if contingent liabilities are included. This debt at today’s low interest rates already consumes 20 percent of the Japanese government budget. Imagine the budget crisis that will occur when inflation and normal interest rates arrive in Japan, on top of ever increasing competition from China and a demographic problem. China hopes to contain its titanic banking problems, which probably exceed a half trillion dollars of bad loans, sectoral industrial over investments and potential real estate bubbles, by an export-led strategy involving continued 30–40 percent annual compound increases in its exports for the indefinite future. Energy prices and terrorist threats are other wild cards in this deck. There is absolutely no room for blunders in coping with this potential witches brew. If we do not find a timely way to address some of these problems, pressures will inevitably build for a return to inflation to ease debt burdens and public entitlement programs. This means a return to the instabilities of the 1970s, and a de facto inflation tax on bond holders and savers in many countries. This will also destabilize politics in some countries, as divergent interests polarize societies. In my view, we urgently need to address our current account problem, unsustainable as it is. We need to accomplish this objective in such a way that the global economy does not crash and burn in the process. This will require a serious effort by the major trading economies to begin easing the pressure from the global savings imbalance problem, domestic structural, fiscal, and banking problems, as well as broader concerns in the trading system as a whole, including the currency issues now under discussion. A major dollar devaluation, as in 1971 and 1985, is an essential part of this needed adjustment. Delaying this effort will build pressure. More US long-term debt, more export capacity built in Asia that will not have long-term US markets, more banking problems, more public debt burdens, and ultimately a much harder landing for the whole world. It also means that the US and the world will remain vulnerable to any unexpected shock to financial markets that could produce general instabilities in currency markets in many countries and great strain on financial and political systems. Correcting these problems will require a major conceptual and political effort, beginning with the G7 leaders. In the April 2006 meeting, G7 finance ministers and central bankers adopted the doctrine of

Leading Essay: Lessons from Adjustment of the Current Account 7

“shared responsibility.” The IMF is coordinating consultations of the countries with major imbalances to develop policies and coordinate adjustment. Multilateral organizations, however, are often better at talking about problems than solving them. The IMF needs to be given a chance to organize a solution before any unilateral efforts are deployed. There is not unlimited time. The US foreign debt from past trade deficits now approaches 4 trillion dollars. This constitutes the largest transfer of wealth in the history of the world and dwarfs the Marshall Plan in scale and impact. This indebtedness cannot continue at this rate without serious damage to the United States and its global position. The eventual solutions will entail serious macro and microeconomic reforms, throughout the global trading system. Richard T. McCormack is Vice Chairman of Merrill Lynch & Co. Inc. He was Undersecretary of State for Economic Affairs, Chief G7 Coordinator for President George H. W. Bush, Ambassador to the Organization of American States and Senior Adviser to the Center for Strategic and International Studies (CSIS) in Washington, DC. He earlier served as a consultant to the Managing Director of the International Monetary Fund. He received a Ph.D. Magna Cum Laude from the University of Fribourg, Switzerland and a BA degree from Georgetown University.

Introduction, Scope and Content

The United States current account deficit (CAD) was $791 billion in 2005, an 18.9 percent increase relative to $665 billion a year earlier.1 The trade deficit was $717 billion in 2005, an increase of 17.3 percent compared with $611 billion a year earlier. Using the estimate of nominal GDP of $12,293 billion by the Congressional Budget Office (CBO), the CAD would amount to 6.4 percent of GDP and the trade deficit to 5.8 percent.2 In mid-2005, trade with China was 30 percent of the US trade deficit and the deficit with the entire Pacific Rim about 50 percent. The North American Free Trade Agreement (NAFTA) members had a share of 17 percent.3 The current account deficit of the US absorbs more than three quarters of the world surpluses. There is valid concern as to how long the US can continue to absorb these huge amounts of foreign financing and how the world economy would react to an exit out of dollar positions. The latest available data for 2005 show the net international investment position (NIIP) of the US at $2546 billion, or 20.7 percent of GDP of $12,293 billion, equal to external assets of $11,079 billion, or 90.1 percent of GDP, less external liabilities of $13,625 billion, or 108.3 percent of GDP. These data and events generate unusual interest in the financial press and in the policy literature. The former Vice Chairman of the Board of Governors of the FRB observed that (Ferguson (2005, 1)): “Not since joining the Federal Reserve Board have I seen this topic show up in the financial press as frequently—and so often with such ominous overtones—as it does these days.” Two distinguished academics describe the nature of the debate (Obstfeld and Rogoff (2005b, 52)): “Nonetheless, in a literature that is often long on polemics and short on analysis, we hope it is useful to have advanced a concrete model on which to base policy analysis.” 8

Introduction, Scope and Content 9

The objective of this volume is to impartially probe the vast findings of this theoretical and policy effort to provide clear thought on the risks of global trade and fiscal deficits for output, employment and stability. The United States needs effective policies toward its trade and fiscal imbalances, in particular, its growing CAD and NIIP. Distinguished economists and policy makers have advanced the concern that an abrupt adjustment of the US could cause a global recession. Various chapters below discuss in turn the current account of the United States, the risks it poses to the internal and world economies, the active policy debate, the economy and external relations of China, Japan, the euro area and the US and a synthesis of sound policy. A chapter relates the findings to currency crashes as important illustrations of how other emerging countries in the world face difficult policies and political choices. The conclusion summarizes the major findings. Cooper (2004) borrows a famous term of John Kenneth Galbraith, conventional wisdom, to label an influential and intellectually elegant proposal to adjust the external imbalance of the United States. The policies of this conventional approach consist of slow depreciation of the dollar, revaluation of East Asian currencies, decrease in demand relative to income in the United States and increase in demand relative to income in Europe and Japan. The Plaza Accord (1985) was one such coordinated effort by the G5 wealthiest countries in the world—the United States, Japan, Germany, France and the United Kingdom. Even such small group of nations bound by some common interests could not agree on the required change of interest rate differentials of the complementary Louvre Agreement. The new policy proposal would require coordinated action by most countries in the world on some of the most sensitive issues of sovereignty, such as domestic employment and exchange rate policy. It also requires economic knowledge and policy instruments that currently are inadequate to implement the proposal. The conventional approach on global imbalances has become official international financial doctrine. This approach is the main policy theme in this volume. The finance ministries and central banks of the Group of Seven (2006) affirmed in their Washington meeting the principle that global economic adjustment is a “shared responsibility.” The meeting stated that greater flexibility of exchange rates would moderate trade surpluses in countries such as China in a shared effort to reduce global imbalances. The ministers and governors supported stronger surveillance by the IMF to maintain consistency between exchange rate and domestic policies.

10 The Global Recession Risk

The Washington meeting produced an annex on global imbalances. The view in that document consisted of three principles for successful adjustment: • It must be shared, requiring participation by all regions • It will require medium-term evolution of private savings and investment and shifts in global capital flows • The optimal solution requires removal of distortions and stronger policies that maximize sustained growth The finance ministers and governors proposed regional policies to reduce the imbalances and promote economic growth: • United States. Fiscal consolidation would raise savings by concentrating on curbs on entitlement spending and increasing private saving • Europe. Recovery should be in the form of demand-led growth together with reforms of labor, product and service markets • Japan. Recovery should proceed with fiscal consolidation and reforms that promote long-term growth • Emerging Asia. The region, especially China, should engage in financial reforms, exchange flexibility to foster revaluation and stronger domestic demand • Oil-producing countries. The oil surplus countries should invest in capacity, improve economic diversification and promote exchange rate flexibility • Current account surplus countries. These countries should promote domestic consumption and investment with improving business environment and market flexibility • IMF. The Fund can make a major contribution by means of multilateral surveillance The Washington meeting gave an additional role to the Fund. The exact nature of this role will develop during meetings of the G7, other forums and, internally, within the international financial institutions. The key forum for international financial architecture (Peláez and Peláez (2005)) is the International Monetary and Financial Committee (IMFC) of the IMF that has the membership of many important member countries. At its April 2006 meeting, the IMFC echoed the G7 statement that the adjustment of the global imbalances is a

Introduction, Scope and Content 11

shared responsibility. It also reiterated the consensus on the required policies: • Increasing national savings in the US with reduction of the budget deficit and promotion of private savings • Structural reforms in the euro area to raise productivity and demand • Higher fiscal consolidation in Japan with structural reforms • Greater exchange flexibility in surplus countries in emerging Asia • Stronger macroeconomic policies and efficient use of savings in oil-producing countries The IMFC requested the IMF to engage in consultations with individual country authorities to produce “modalities” that promote actions to reduce the imbalances. The proposal by the Managing Director to organize multilateral consultations could constitute an important vehicle to generate action on the imbalances. The Managing Director of the IMF outlined the view on the risks of the imbalances and the role of the Fund (de Rato (2006)). He adopted the proposition that the CAD of the United States is not sustainable, having the risk of disorderly correction. US consumers could not support indefinitely demand in the rest of the world and various countries would not finance the imbalances. The policy should focus on gradual reduction of the imbalances to avoid sudden disorderly adjustment. In a run out of dollar assets, there would be exchange rate depreciation and increases in interest rates, triggering financial disruption that could accentuate output and employment losses. De Rato argues that there is some consensus of the required policies but no joint action. The policies would consist of fiscal consolidation and increases in private savings in the US, stimulus of domestic demand and further revaluation in some Asian countries and structural reforms to encourage demand and raise productivity in the non-tradable sectors in Europe and Japan. The Managing Director of the IMF is implementing multilateral consultations in addition to the enhanced surveillance. In 2006, the Fund is conducting the first multilateral consultation on reducing global imbalances and maintaining strong global growth. The core group of participants are the US, the euro area, Japan, Saudi Arabia and China. The discussions will spread to the Executive Board of the IMF and at the ministerial level to the IMFC that have broad member representation. The expectation is that this cooperation will help to unwind the global imbalances, paving the road for sustained growth while demand and savings adjust.

12 The Global Recession Risk

According to Truman (2006Jul12), the effort of multilateral surveillance is not complete. The multilateral consultations could be ambitious in content and timetable. Truman argues that the Fund members are not allowed by the articles of agreements to prevent balance of payments adjustment. The managing director of the Fund must act as “overseer of the system.” There are multiple lags in the effect of policy. There has been a long lag between the need for action and the recognition of the need. With some important exceptions, economists and policy makers did not fully focus on the risks until about 2004 after recovery of the US from recession. There is an even more complex lag between recognition of the need of policy measures and an international agreement on the types of policies and required doses. Such an agreement would be a major diplomatic challenge. The major trade deficit country, the US, has fiscal deficits but this is also the case of Japan and Europe. Moreover, China has its own disguised deficit in non-performing loans in banks of about 40 percent of GDP. All trade deficit and surplus countries have major distortions that require reforms, which are politically difficult. There is a long lag between the actual taking of policy measures and the effects on economic variables. For example, economists largely agree that there is slow pass-trough of depreciation to relative prices. It would take substantial devaluation and a long period to reverse the trade deficit of the United States. Imports of goods and services in 2005 were $1992 billion, 56 percent more than exports of goods and services of $1275 billion. Reallocation of resources away from nontraded goods, such as real estate, to tradable goods may take a substantial amount of time. A favorite hypothesis of feasibility by the IMF is a US CAD of 3 percent, that is, roughly one-half of the current number. Even such an improvement would require a major depreciation of the dollar relative to the currencies of the surplus countries. Adjustments in markets do not move or stop at levels desired by policy makers. There would have to be major wealth and resource transfers in the US economy and in those of other countries. The important concept of overshooting of Rudi Dornbusch could suggest that exchange rates will anticipate in timing and speed policies or concerted diplomatic initiatives. There are numerous practical hurdles in large scale coordinated exchange and income policy by many nations beyond diplomatic impracticality. Two examples help to identify difficulties. An investment fund, Long Term Capital Management (LTCM), was managed by

Introduction, Scope and Content 13

talented, experienced and successful fund managers, including two Nobel laureates in finance. LTCM leveraged $7 billion in equity to create assets of $125 billion. The strategy was “convergence arbitrage.” The hedge correlations changed during the Russian Crisis of 1998, converting the position into the return of a naked short option (Jorion (2000)). LTCM had centralized management without need to persuade traders. The policy proposal to coordinate currencies is across a world with output of $44 trillion. It is doubtful that there is knowledge on the appropriate doses of policy impulses and sufficient diplomatic leverage, much the same as in the Plaza Accord and the Louvre Agreement. The lag between the need, diplomacy, action and effects may be too long. Exchange rates do not move slowly. If market players anticipate a trend, leveraged trades would tend to accentuate the trend. Although there is no rigorous empirical verification, the concept of overshooting (Dornbusch (1976), Obstfeld and Rogoff (1996) and Rogoff (2002)) perceptively suggests the faster and earlier movement of exchange rates relative to prices of goods and services. Coordination of policy requires agreement of many nations. Thus, markets will identify and accentuate the trend. In January 1999, in the midst of a capital outflow, Brazil installed a new governor of its central bank. The policy by this new governor was a broader band of depreciation with a maximum rate by year end. The Brazilian currency depreciated to the maximum rate immediately after the market opened, causing an explosion of country risk and the black market rate of exchange. Within a month, a third governor floated the currency. It may be impractical to depreciate a currency over the long-term to correct the CAD. There would be an overshooting once the policy intention is known. It is even more difficult to coordinate a currency change among many countries—with structural and institutional weakness in Europe and Asia—without an overshooting. The CAD adjusted very rapidly in nearly all recent emerging market crises—Brazil 1983–84 and 2002–04, Mexico 1994–95, Argentina 2001–05 and Asian Five 1997–98. The CAD also adjusted during the business cycle in industrial countries without major disruption. Authorities do not control the speed of adjustment of currencies that are perceived under threat. Currency rate fluctuations follow capital flows, which reverse direction almost instantaneously in the current world. There is another illustration of the practical obstacles to policy doses. Greenspan (2004Jan3) revealed that the FRB has managed monetary policy following a broad risk management approach. There are multiple

14 The Global Recession Risk

limitations in risk management at the micro level, raising questions of its use at the macro level. The Basel Committee on Banking Supervision (BCBS) of the Group of 10 has completed a new capital regulation framework with outstanding contributions by central bankers, practitioners and academics (Basel Committee (2004); Peláez and Peláez (2005, 242–82)). The BCBS concluded that there is not sufficient knowledge of credit risk management for a unified regulatory standard. Accordingly, Basel II has an advanced internal-ratings based approach in which banks use their own credit risk models when meeting minimum requirements. Evidently, managing banks is less complex than managing currencies and macroeconomic policies across the world. To be sure, scholars in theory and policy have significantly advanced knowledge but substantial disagreement and imprecision remains. Thus, there is no theory or policy standard. Model and data errors are likely to abound. The conventional approach is unfeasible without credible institutional reform in Europe and the Far East. Policy coordination could follow the suggestions of the IMF (Rajan (2004)). The euro area and Japan require structural reforms. East Asian countries could combine more exchange flexibility with profound reform of their internal financial sectors, especially in China and Japan. The Fund, the United States and the G7 have advised China that flexibility of the renminbi (CNY) is in the interest of price stability, sound domestic growth and a favorable global environment. China has started the painful process of changing the exchange regime. Credible institutional reform in key regions may slow depreciation of the dollar, buying time for effective shift of production in the United States from non-traded to traded goods in accordance with the proposal of Obstfeld and Rogoff (2005a–b). According to research by the FRB, a reduction of $1 of the US fiscal deficit reduces the trade deficit by $0.20. The fiscal deficit would not be the cause or remedy of the US CAD. If the upswing of the business cycle in the United States is lasting, there may not be a global recession. There is another current of thought that explains the US CAD in terms of a glut of world savings instead of the more conventional approach of savings and investment. There is additional research on the relative rates of return of US external assets and liabilities and their valuation at market prices. This research suggests that there are mitigating processes of the US CAD. Valéry Giscard D’Estaing characterized the denomination in dollars of the United States external liabilities as an “exorbitant privilege” (Gourinchas and Rey (2005)). The United

Introduction, Scope and Content 15

States has become a venture capitalist borrowing at low rates in liabilities denominated in dollars to invest at higher rates and equity premium in assets denominated in other currencies. There is an income effect in higher yields of assets than liabilities. Moreover, the depreciation of the dollar during an adjustment of the CAD increases the market value of net external assets of the US. The possibility of an abrupt adjustment is the main threat of the large and growing US CAD and NIIP. The research by the FRB shows that such an abrupt adjustment has not occurred in the case of industrial countries. However, the fact that it has not occurred does not prove that it may not occur. It is possible that foreigners may be unwilling to increase their positions in US financial assets at prevailing interest rates. An exit out of dollar assets could cause major devaluation of the dollar. This depreciation of the dollar would cause inflation in the US, leading to increases in American interest rates. There would be an increase in mortgage rates followed by deterioration of real estate values. The IMF has simulated that such an adjustment would cause a decline in the rate of growth of US GDP to 0.5 percent over several years. The decline of demand in the US by four percentage points over several years would result in a world recession because the weakness in Europe and Japan could not compensate for the collapse of American demand. The probability of occurrence of the abrupt adjustment is unknown. However, the adverse effects are quite high, at least hypothetically, to warrant concern. Chapter 1 provides a framework of data to introduce the issue and a detailed exegesis of the policy contributions. These contributions are divided into two major currents, which actually mesh in many cases. The savings and investment approach typically departs from the definitions of the national accounts, which show that a current account deficit is equal to an excess of investment over savings financed with foreign savings. A country’s national savings is equal to household savings plus corporate savings less the budget deficit. National savings would equal investment in a closed economy. In an open economy, investment can exceed national savings because of the opportunity to borrow abroad. The CAD is the excess of payments abroad over receipts from foreigners. Thus, the CAD is the shortfall of national savings over investment. Another current of thought explores global financial savings and their determination. The two approaches lead to somewhat different policy proposals and assessments of the risks of the large and growing US CAD. Unfortunately, the profession has not found a definitive theoretical and empirical answer on the

16 The Global Recession Risk

probability and timing of existence of a point when there could be an abrupt exit out of US financial assets. The conventional approach to policy, as well as the recommendations of the IMF, proposes flexibility of Asian currencies, but for somewhat different reasons. The conventional approach finds that flexibility of Asian currencies would reverse the trade deficit of the US versus Asian currencies. The IMF develops a different interpretation of the value of the Chinese currency and grounds for exchange rate flexibility because it would promote a more efficient Chinese economy. A main approach of this volume, following abundant evidence, is that there are fiscal deficits and domestic distortions requiring broad reforms in Asia and the US, EU and Japan (G3) that are critical to a solution of the US CAD and the global risks. Adjustment by the US alone would be insufficient. China has a large hidden fiscal deficit to be realized in the future in rescuing its banking system plagued by non-performing loans. In addition, as the IMF has documented, the repatriation of capital in expectation of speculative gains during a revaluation explains the continuing undervaluation of the Chinese currency. The revaluation faces difficult internal economic and political obstacles. Chapter 2 consists of an analysis of the economy of China with emphasis on the obstacles to required reform. Japan stoically suffered a lost decade of stagnation and deflation. While Japan, as China, has a large current account surplus as percent of GDP, it has a large fiscal deficit and net public debt of 80 percent of GDP. Japan also has a challenge in terms of the future entitlements of an ageing population and the need to increase productivity in order to grow. Moreover, there is not sufficient political consensus on required economic reforms. The proposals of the IMF and the conventional approach require growth of demand in Japan and an exchange rate that reduces its trade surplus. However, Chapter 3 provides information and analysis showing the restrictions of required change in Japan. The election in September 2005 merely gave Prime Minister Koizumi the mandate to privatize Japan Post, the largest financial institution in the world with assets of $2–3 trillion, but only by 2017. The will for reform of a party that has been in office for five decades, the Liberal Democratic Party (LDP), may be exhausted. The euro zone also has large and growing fiscal deficits. It faces future stagnation because of the entitlements of an ageing population. Productivity change has fallen behind such that potential output growth is 1–2 percent below that of the US. The European Commission is trying to revitalize the Lisbon Agenda to increase productivity that

Introduction, Scope and Content 17

could lead to a more dynamic EU. However, inflexible product and labor markets inhibit innovation. The US has 17 of the top 20 universities in the world with production of knowledge focused toward innovation. Europe requires a fresh approach to knowledge, innovation and economic organization. However, the German election of September 2005 resulted in a perfectly divided legislature, leading to another grand coalition, which may not be ideal for required reforms. Italy also experienced a neatly divided election, diminishing hopes for structural reforms. The effects of an exit out of dollar assets could have profound effects on emerging markets. The lowering of the fed funds rate to 1 percent caused a hunt for higher yields by investors. The Global Financial Stability Report April 2006 of the IMF shows that the issue of bonds, loans and equities of emerging countries reached $406.4 billion in 2005, an increase by 41.6 percent over the record $286.9 billion in 2004. The gross issue of emerging country bonds reached $182.2 billion in 2005, an increase by 35 percent over the record in 2004. The global emerging market bond index (EMBI) declined in spread from 735 basis points in 2000 to 482 in the first quarter of 2004 and to 210 in the beginning of 2006. The spread of the Merrill Lynch high-yield index declined from 890 basis points in 2000 to 404 in the first quarter of 2004 and to 342 in the beginning of 2006. The disorderly devaluation of the dollar would allegedly be accompanied by a rise in interest rates and a flight of financial assets into higher quality. There could then be a rise in spreads in emerging and other high yield markets. The shrinking market of exports to the US could weaken balance of payments fundamentals of emerging countries. There could be a repetition of the currency crashes of the emerging market crises of the past 20 years. There is a group of serial defaulting countries that have limited tolerance of debt, defaulting with debt ratios that are manageable for G7 countries. There is a threat in the disorderly adjustment of the dollar of crises in various emerging countries. Economists and practitioners have developed powerful analysis of currency crashes, policies and portfolio strategies. Chapter 5 considers the major theories and empirical research on currency crashes in recent literature: sudden stops, currency mismatches, original sin and debt intolerance. There are some practical illustrations of country strategy and portfolio management. There is perhaps too much optimism on the policy alternatives of the US. The objectives of policy are internal and external balance with price stability. However, there may be only one suspect instrument, the policy rate of the central bank, or fed funds rate. The executive does not

18 The Global Recession Risk

fully control the budget. It is unlikely that Congress would approve a drastic reduction of the deficit, either by expenditure reduction, tax increases or a combination of both. Congress would have to be persuaded into provoking a global recession in the short-term, by abruptly eliminating the fiscal deficit, to avoid a global recession in the future as investors exit dollar assets. In addition, economists would show that the fiscal and current account deficits have moved in opposite directions in many cases. The measurements in the literature do not support the “twin deficit” theory that fiscal deficits cause current account deficits. Chapter 6 considers the important issue of technical restrictions of policy design and execution, summarizing the conclusions on the policy debate of adjustment of external imbalances. There is a Conclusion with a summary of the findings. The increase in oil prices during a world economic boom added another dimension to global imbalances. The IMF forecasts the US CAD at $900 billion in 2007. The combined current account surplus of Japan and other advanced countries would be $285 billion, or 32 percent of the US CAD. However, the combined surplus of China ($190 billion) and the fuelexporting countries ($424 billion) would be $614 billion, or 68 percent of the US CAD. The new G7-IMF doctrine of “shared-responsibility” requires the more complex cooperation of the fuel-exporting countries with a large surplus of savings over investment and a current account surplus equivalent to 47 percent of the US CAD. An Appendix with data and a bibliography complete the volume. The official doctrine of shared responsibility encounters major hurdles. If the disorderly adjustment of the dollar has predictive value, the private sector will force abrupt and probably costly adjustment. Consider what regions must accomplish. Americans must save more by reducing their superfluous consumption. The US must abandon residential construction in favor of export activities and the rest of the world must buy American goods and services. The US government as well as those of surplus countries must engage in fiscal consolidation. Europe must become more efficient, reducing entitlements and increasing investment and consumption while reducing public deficits. Japan must also become more efficient, abandoning protection of agriculture, revaluing its currency and reducing its internal debt and deficit. Chinese leaders must overcome their fears of protests, lower growth with higher unemployment and agricultural price deflation, revaluing the currency to diminish their trade surplus with the rival US. Oilproducing countries must invest in their economies in projects for which there may not be markets and skilled labor. Elections and parlia-

Introduction, Scope and Content 19

ments in Germany, Italy, Japan, Mexico and the US, as well as political fears in China, show that there is no political capital for such drastic changes. This profound structural change over many regions may require more time than the almost immediate jumps in exchange rates. The G7-IMF doctrine may be sound but its implementation may miss the timing of a disorderly adjustment. Stock market indexes have predicted many recessions that never occurred. Economists have predicted many catastrophes that also did not occur. The best hope for the world economy is that the disorderly correction has no predictive value.

1 Policy Contributions

The United States current account The data to illustrate concern with the current account of the United States are shown in Table 1.1. There is an additional Table A in the Appendix with data since 1960.

Table 1.1 $ billions

US, current account, NIIP, fiscal balance, debt and nominal GDP

1997 Goods and services Income Unilateral transfers Current account Nominal GDP CAD/GDP % NIIP NIIP as % of GDP Exports of goods & services NIIP as % of exports Fiscal balance, FB FB as % of GDP Internal debt, ID ID as % of GDP

1998 1999

2000

–108 –165 –263 –378 13 4 14 21 –45 –53 –50 –58 –140 –213 –299 –415 8187 8626 9127 9708 –1.7 –2.5 –3.3 –4.3 –822 –1070 –1037 –1581 –10.0 –12.4 –11.4 –16.2 935 933 966 1071 88 –22 –0.3 3772 46

–115 –107 69 126 0.8 1.4 3721 3632 44 41

–148 236 2.5 3410 36

2001

2002

2003

2004

2005

–363 –421 –495 –611 –717 25 12 36 27 11 –52 –63 –69 –81 –86 –389 –472 –527 –665 –791 10060 10378 10810 11545 12293 –3.9 –4.5 –4.9 –5.7 –6.4 –2339 –2454 –2339 –2448 –2546 –23.2 –23.6 –21.6 –21.2 –20.7 1005 975 1016 1152 1275 –233 128 1.3 3320 33

–252 –158 –1.5 3540 33

–230 –378 –3.4 3913 35

–212 –413 –3.5 4296 37

–199 –318 –2.6 4592 37

Note: NIIP is net international investment position with FDI at market value. Fiscal Balance is revenues less outlays. Internal debt is debt held by the public. Sources: GDP, http://www.bea.doc.gov/bea/dn/home/gdp.htm Current account and exports: http://www.bea.doc.gov/bea/di/home/bop.htm NIIP: http://www.bea.doc.gov/bea/di/home/iip.htm Fiscal balance and debt held by the public: http://www.cbo.gov/showdoc.cfm?index=1821&sequence=0#table2

20

Policy Contributions 21

The first block of numbers shows account balances that compose the current account. The United States has been running a trade deficit for many years. However, there was acceleration of the deficit in 1999 and 2000, when it reached $378 billion, or 3.9 percent of GDP. The behavior of the current account mirrors that of its main component, the balance of goods and services. The CAD jumped from $299 billion in 1999 to $415 billion in 2000, or 4.3 percent of GDP, and then to $665 billion in 2004, or 5.7 percent of GDP. The estimate for 2005 is $791 billion or 6.4 percent of GDP. The NIIP of the United States followed the deterioration of the trade and current accounts. There was again a large jump from 1999 to 2000, reaching $1581 billion, or 16.2 percent of GDP, and then $2339 billion, or 21.6 percent of GDP, in 2003. In 2004, the NIIP reached $2448 billion or 21.2 percent of GDP and $2546 billion in 2005 or 20.7 percent of GDP. Another weakness of the United States external position is that the NIIP is over two times exports. The fiscal balance of the United States shifted from surplus in the late 1990s to a deficit of $413 billion in 2004, or 3.5 percent of GDP, declining to 2.6 percent of GDP in 2005. However, the debt held by the public stabilized close to 40 percent of GDP. These external and internal imbalances are termed “twin deficits” in the literature on the United States in the 1980s. Adjustment of similar deficits has been sharp and painful in terms of loss of output—ranging from around 5 percent for Mexico and Argentina in 1995, through average 7.2 percent for the Asian Five in 1998 and 15 percent in the first quarter of 2002 for Argentina. Evidently, emerging market crises are less relevant to the largest economy in the world whose currency, the dollar, is the standard reserve. The United States does not have a currency mismatch because it borrows on its own currency. Nevertheless, there is concern if eventual adjustment of the United States would have an impact on economic conditions globally because of its high share in world output. As typical, economists disagree on the risks and policies required for adjustment.

Risks A set of policies for adjustment of the current account could switch expenditures to improve the trade account by means of changes in relative prices. Another set of policies could reduce expenditures to adjust import demand. The major risk of the United States current account is the possibility of recession in the United States that could have adverse

22 The Global Recession Risk

impact on the rest of the world. In fact, the recent recovery of the world economy was positively influenced by recovery in the United States. The IMF and economists have developed methods to measure sustainability of debts. Recent measurements of the sustainability of the United States are quite pessimistic, showing rapid increase in deficits in trade and current account and in debt. As with all economic measurements, there are restrictive assumptions in these methods and difficulties in measurement. This section considers alternative views on the threats posed by the United States CAD as analyzed in professional literature. The Economic Counselor of the IMF, Raghuram Rajan (2004), argues that the dollar/euro rate is not at a historical high when using synthetic data for the euro dating back to the 1980s. In his opinion, there is cause for concern about the American CAD but no need for panic. The essence of policy concerns should be on global imbalances. Rajan reminds that the CAD originates in an excess of investment over savings. During the last few decades, the gap of public investment over savings has been negative with partial compensation by an excess of private savings over investment. There was an interruption in the bubble years of the late 1990s when private investment soared while savings increased moderately. The CAD increased even with fiscal surpluses. However, the United States experienced fiscal deficits in recent years, with negative public and private investment balances. However, Rajan warns that the world would still be in recession without these negative investment balances in the United States. There is no individual country, according to Rajan, to blame for the global imbalances, which originate in global disequilibrium. It is more constructive to consider policies that could mitigate imbalances. Data suggest the need for higher savings in the United States, more rapid growth in Europe and Japan, higher savings in ASEAN and higher consumption in China and the newly industrialized economies (NIE). The IMF estimates that the United States can maintain a CAD of around 2–3 percent of GDP without undesirable effects (Rajan (2004)). Higher productivity growth and younger population contribute to this calculation of a sustainable CAD. That is, the United States should reduce its CAD from 5.5 percent of GDP to 3 percent, or by 3.5 percentage points. Following calculations by Obstfeld-Rogoff (2005a), Rajan argues that because traded goods are only 30 percent of GDP, reduction of the CAD by 3.5 percentage points would require that

Policy Contributions 23

spending on traded goods decline by 10 percent. However, remaining production in the United States cannot be traded. Prices of non-traded goods would have to decline relative to traded goods to maintain consumption of non-traded goods in order to avoid a recession, with adverse impact on the entire world. Therefore, the dollar in real terms would have to depreciate significantly to make traded goods more expensive. The timing of depreciation could be crucial (Rajan (2004)). There is low pass-through of depreciation to inflation in the United States. Thus, higher dollar depreciation is required in the short-term rather than in the long-term to increase effectively the ratio of prices of tradables to non-tradables. In addition, it takes time for American economic activity to shift production away from non-tradables to tradables. Accelerating depreciation in the short-term may overshoot the ratio of prices required to attain a sustainable CAD. The data on financing of American external liabilities is perceptively interpreted by Rajan. The foreign private sector purchases twothirds of financial assets sold by the United States. There are two equally valid statements. First, foreign governments finance the American CAD and foreign private investment in the United States matches American investment abroad. Second, foreign private investors finance the American CAD and foreign central banks finance American investment abroad. These are merely different arbitrary ways to allocate capital flows, which are not earmarked. The first statement is more common and causes high concerns. Rajan is more concerned with the second statement because of its implications for investor expectations. There have been changes in investor preferences in the past four years. The private sector has concentrated investment in corporate and agency bonds, avoiding equities and Foreign Direct Investment (FDI). The foreign government sector has concentrated in treasury securities to hedge currency movements. Rajan believes that expectations of total returns by the foreign private sector will prove crucial in the future financing of the American CAD. Some authors argue that the American CAD in the mid-late 1990s reflected excess of private investment over savings (Roubini and Setser (2004)). However, in recent years, the CAD originates in growing budget deficits. In the interpretation of Roubini and Setser, the United States borrows from abroad to finance the fiscal deficit. Increasing consumption limits the capacity of the United States to finance the fiscal deficit and private investment with domestic resources.

24 The Global Recession Risk

Roubini and Setser identify several adverse consequences of a large net external debt of the United States: • Net interest payments will become a burden to the economy • A large CAD limits the CAD in future periods of full employment • Growing debt/GDP ratios can cause difficulties in financing sustainable trade and current account deficits • There could be vulnerability to financial shocks that could cause loss of confidence by investors with possible increase in debt burden There are various risks in financing the United States CAD with savings of other countries (Summers (2004a)). Summers points to growing protectionism in the United States because of the impact of imports on production, wages and employment. In addition, he emphasizes the “balance of financial terror,” defined as the costs to other countries of not financing the American CAD as determent to stop the flow of financing. In addition, the low yield of investment in United States assets together with the expectation of dollar depreciation could cause significant losses. Fixed exchange rates are preventing monetary policy in countries such as China. Europe absorbs most of the depreciation of the dollar because of flexible currencies. There is a distinction between a growing CAD financing investment from the current one financing consumption (Summers (2004b)). Investment is concentrating in non-traded goods, such as real estate, instead of in traded goods. Another feature is that short-term investors finance 50 percent of the United States CAD. There is analysis of the possibility of inflation and recession resulting from the American CAD (Bergsten and Williamson (2004)). The emphasis is on a growing ratio of external liabilities to GDP. One common scenario is that reversal of financing flows of American external liabilities could cause a sudden and sharp reduction in the value of the dollar. If the economy were close to full employment, depreciation could accelerate inflation. Resulting increases in interest rates by the FRB could cause increases in long-term interest rates, which could lead to recession in the United States. However, Bergsten and Williamson consider also a scenario in which there is no inflation but depreciation is not effective. Dollar depreciation may fail in shifting demand in other countries toward American goods and services. They argue that this would be the more likely case of a world recession caused by dollar depreciation. In both scenarios,

Policy Contributions 25

there could be a rise in support for protectionism, both in the United States and in the rest of the world. Wolf (2004Aug24) argues that there should be concern on the United States CAD because: American savings may be relatively low, there could be a waste of savings by other nations and reversals of capital flows may prove destabilizing for the world economy. The dollar is the world’s currency reserve. American financial liabilities are denominated in dollars or are claims on real assets with flexible prices. Thus, there are not currency mismatches such as those that characterize emerging market crises. However, the United States may require significant depreciation of the dollar to stabilize the CAD as a share of GDP. Thus, anticipation of the risk of depreciation may cause lowering exposures, further weakening the dollar. In another article, Wolf (2004Dec7) uses IMF data to show that the current account deficit of $600 billion of the United States is financed by Japan, 25 percent, euro area plus Denmark, Norway and Sweden, 22 percent, the Middle East, 16 percent, and non-Japan Asia, 24 percent. According to him, the surprising behavior is by non-Japan Asia, one of the fastest growing regions in the world, which should run external deficits to finance absorption of technology and development. Reduction of the external imbalance of the United States by tight monetary and fiscal policies would cause a world recession. Wolf shows that foreign governments financed 43 percent of the American current account deficit accumulated in 2002, 2003 and the first half of 2004. According to a survey of 65 central banks controlling assets of $1700 billion, by Central Banking Publications, there have been major changes in views in the past two years (Giles (2005a)). In particular, 70 percent of central bank reserve managers increased exposures to the euro. In 2003, central banks held 70 percent of official reserves in dollar-denominated assets. Purchases of American securities by central banks financed more than 80 percent of the CAD in 2003. Moreover, 47 percent of reserve managers expect reduced growth of reserves to 20 percent in the next four years compared with growth of 66 percent in the prior four years. More than 90 percent of these reserve managers considered income to be important in investment. Perhaps the greatest concern originates in research on the sustainability of the current account.4 Roubini and Setser (2004) explain the sustainability of the CAD in terms of sustainability of the United States foreign debt. The sustainability of debt depends on the willingness of other countries to continue to finance debt at a “reasonable” cost.

26 The Global Recession Risk

They argue that the key issue is whether the United States can continue to finance a large and growing CAD. While it is a fact that many countries normally finance high debt and CAD levels, Roubini and Setser contend that this may not be the case of the United States. There are three factors of concern about the United States. The CAD of the United States is very high, absorbing two-thirds of the world’s current account surpluses, and is growing very rapidly. Financing a debt of 50 percent of GDP of the United States is equivalent to around 50 percent of $11–12 trillion, absorbing a significant share of crossborder financial assets. Another adverse structural characteristic is that exports are only around 10 percent of GDP in the United States, which makes adjustment more difficult. Roubini and Setser consider three scenarios: a baseline with growing trade deficit, a second scenario with constant trade deficit and a third scenario with declining trade deficit. The baseline scenario of Roubini and Setser is CAD of 7.1 percent of GDP in 2006 and 8.1 percent of GDP in 2008 with corresponding net external debt/GDP of 40 percent and 50 percent. A second scenario shows CAD of 8.2 percent of GDP by 2010. Their optimum scenario is one of “strong, smooth, sustained adjustment.” The main characteristic is a major reduction of the trade deficit in 2005–15, which will stabilize the debt to GDP ratio. The ratio of the CAD to GDP would begin to decline, reaching 4.3 percent in 2012. The main condition of external solvency, according to Roubini and Setser, is that the discounted sum of all future trade balances equals the initial foreign debt. Solvency requires that a country with trade deficits must eventually reverse them into surpluses. Investors must assess that the path of adjustment is credible to avoid abrupt reversals of financing. However, analysis of sustainability focuses on conditions that arrest growth of the debt to GDP ratio. The rationale is that a country with an exploding debt to GDP ratio may become insolvent in the future. The model used by Roubini and Setser defines the resource gap as: Required balance of trade, transfers and remittances to stabilize debt/GDP LESS Actual balance of trade, transfers and remittances The required balance is a function of the difference between the real interest rate, r, and the growth rate of the economy, g, times the

Policy Contributions 27

debt/GDP ratio, d. The higher the difference between the real rate of interest and the growth rate of the economy and the higher the debt level the higher is the required balance. If the real rate of interest exceeds the growth rate of the economy, a trade surplus would stabilize the debt/GDP ratio. The example by Roubini and Setser for the United States in 2003 is: (r – g)d = (–0.025 – 0.03)24.1% = –1.33%

1.1

They calculate the real rate of interest as –2.5 percent, the growth rate of the economy as 3 percent and the debt/GDP ratio as 24.1 percent. In this example, the deficit of the balance of trade, transfers and remittances that would stabilize the debt/GDP ratio at current levels would be 1.3 percent of GDP. However, the actual deficit of the non-interest balance is 5.13 percent. Thus, the adjustment required for stability of the debt/GDP ratio is 5.13 percent less 1.3 percent equal to 3.8 percent of GDP, or around $400 billion, what Roubini and Setser call the “resource gap.” This would require a major effort of growth of exports over imports, especially because of their difference in dollar value. Consider a real rate of interest of 3.5 percent, growth of the economy of 3.5 percent and deficit of trade, transfers and remittances of 5 percent. The debt/GDP ratio would grow by 5 percent per year. Six years later, by 2010, the debt/GDP ratio of the United States would increase by 30 percent, reaching 58 percent because it starts at 28 percent in 2004. In the baseline scenario of Roubini and Setser, with increasing trade deficit, the resource gap is 7.8 percent of GDP by 2010, 5.5 percent in the second scenario of constant trade deficit and 2.6 percent in the scenario of declining trade deficit.

Savings and investment There are numerous proposals on how to adjust the United States CAD. One of the most popular proposals combines depreciation of the dollar extended to Asian countries, in a coordinated international policy effort, a lowering of the relative rates of growth of demand and output in the United States, an increase in the relative rates of growth of demand and output in Europe and Japan and a slow pace of adjustment to allow for full expenditure switch. Another proposal focuses on reduction of the fiscal deficit in the United States together with flexibility of Asian currencies. There are several proposals that would leave the

28 The Global Recession Risk

current state of nature unaltered based on various analyses that the United States CAD is sustainable for the medium- to long-term. It is instructive to consider these proposals. Wolf (2004Dec21) defines the objective of policy as reduction of excess demand from the United States and other high-income countries without a decline in global economic activity. He argues that this would be accomplished with a reduction in aggregate demand relative to potential supply in deficit countries and with increases in demand in surplus countries. Simultaneously, the currencies of deficit countries would have to depreciate to switch output toward tradable goods and services while restraining demand. Wolf believes that the problem was not created by the United States but jointly by many regions and countries. There could be a concerted solution. The departure for Wolf is the proposition of Raghuram Rajan (2004), Economic Counselor of the IMF, that the “sustainable” deficit of the United States over the long run is about 3 percent of GDP. Such a deficit would correspond to the long-term surpluses of high-income countries such as Japan and Europe. Wolf argues that the dollar would have to depreciate an additional 30 percent to attain required expenditure switch. Simultaneously, non-Japan Asia would have to become a net importer of capital, running current account deficits of $150 billion a year. The reversal of the CAD requires a decrease in demand of United States non-traded goods to generate the necessary increase in savings and an increase in foreign non-traded goods (Obstfeld and Rogoff (2005a)). These authors argue that even a further 20 percent depreciation of the trade-weighted dollar exchange rate would only reduce the CAD of the United States by one-third. Their calculations suggest that most of the adjustment will come in the form of increased savings and productivity change. An important consideration is the slow passthrough of depreciation to prices of goods and services. Thus, slower depreciation of the dollar may allow for effective pass-through, resulting in a cumulative lower depreciation of 16–26 percent in their model. In case of an overshooting, a depreciation of the dollar of 40 percent may be required to effectively change relative prices and reallocate productive factors. In terms of historical parallels, Obstfeld and Rogoff believe that the current adjustment of the CAD of the United States may resemble more the disruption occurring after the end of the Bretton Woods system in the early 1970s than the benign adjustment after 1987. They point to complications in the current environment such as high security expenditures, increasing energy

Policy Contributions 29

prices, escalating retirement costs and the need to increase real rates of interest. Obstfeld and Rogoff (2005b) observe that the United States CAD is equivalent to 75 percent of the combined current account surplus of all the world’s surplus countries. The elimination of the CAD solely through exports would require an increase of 70 percent of export revenue. Several factors contributed to risks of this high CAD: • collapse of savings to 1 percent of GDP because of the rise in equity and housing values • growing fiscal imbalance • increasing oil prices • dependence on financing of the CAD by Asian central banks and unstable oil-producing countries • structural inflexibility of Europe • Japan’s continuing export-led growth model • vulnerability of emerging markets to crises • increasing bank counterparty credit risk to non-bank entities (insurance companies, hedge funds and others) • “open ended” financing burdens of wars and homeland security Obstfeld and Rogoff (2005b) recommend the initiation of an adjustment process of the CAD, beginning with a stronger effort to reduce the fiscal imbalance and measures to deal with retirement and health costs. The rationale for the adjustment of the fiscal imbalance is the increase in savings. In addition, they argue that Asia, in particular China, must absorb a proper share in the burden of adjustment. In one of their scenarios, a reduction of the CAD by three percentage points, toward the IMF-acceptable 3 percent of GDP, would require a depreciation of 25 percent relative to non-Asian currencies. Obstfeld and Rogoff (2005b) observe that the trade account is the major component of the CAD. According to their calculations, rapid adjustment of the United States trade account would require a major depreciation of the dollar, on the order of 30 percent. Because of low pass-through of depreciation to inflation and sticky prices, less painful adjustment requires a longer period. More time would permit flows of labor and capital among regions and countries, mitigating the need for currency depreciation. According to Obstfeld and Rogoff (2005a), the financial globalization argument may be a “double-edged sword.” They observe that the United States is highly sensitive to increases in interest rates because it

30 The Global Recession Risk

borrows on bonds at lower short-term interest rates, such as those paid on reserves held by foreign central banks, and lends on equity, appropriating the equity premium. Their calculations show that an increase of 1.25 percent in the short-term debt compensates for the revaluation of net positions with foreigners caused by dollar depreciation. They argue that concentration of risk has increased counterparty risk. In sum, Obstfeld and Rogoff (2005a) doubt that the valuation of the net foreign position of the United States can proceed in an orderly fashion with continuing deterioration of the CAD. In one of their scenarios, elimination of the external imbalances of Asia, Europe and the United States would require a depreciation of the real dollar exchange rate by 33 percent and of the nominal rate by 35 percent. Regionally, the dollar would depreciate by 35 percent relative to Asian currencies and by 28 percent relative to the euro. The halving of the CADs would require a depreciation of 17 percent. However, if Asia maintains the peg relative to the dollar, the adjustment of the CAD would require a depreciation of 50 percent relative to European currencies. The American economy does not have sufficient manufacturing capacity for import substitution and exports stimulated by depreciation of the dollar, as argued by Hale (2005). He notes that the CAD of the United States is 40 percent of manufacturing production of $1.5 trillion. The rate of capacity utilization would have to jump from 79 to 86 percent to generate a trade surplus of $150 billion. Dale estimates that capacity would have to rise to 100 percent for the United States to eliminate entirely the CAD. Reduction of the deficit only through import substitution and exports would require growth of production capacity of traded goods. Recovery of corporate profits after the recession, possible tax incentives and foreign direct investment could contribute to an increase in capacity. Wolf (2004Nov30) estimates that the depreciation of the dollar by the end of 2004 was around 17 percent, suggesting that adjustment requires an extra 35 percent depreciation. The United States experienced net outflows of FDI and equity investments of close to 2 percent of GDP in 2003–04. This has been compensated with investment by foreign governments in American external liabilities. Wolf argues that exchange rate risk in the form of the vulnerability of the value of the dollar is an important reason for an outflow of private resources from America. This risk is related to the calculation of depreciation of the dollar required to adjust the current account deficit.

Policy Contributions 31

Wolf (2004Nov23) argues that the adjustment of the United States current account requires cooperative action by major players in the world economy. He argues that this adjustment also requires changes in relative prices, or real exchange rates, and in growth of supply and demand worldwide. Wolf identifies three myths concerning the causes of the American CAD: attractive real returns, high rates of economic growth and fiscal deficits. Less than 40 percent of American external liabilities are FDI and corporate equity with the bulk consisting of bonds, bank loans and similar assets. The rise in the CAD originates in an uncompetitive exchange rate, which causes lower rates of production of tradables relative to non-tradable goods. The challenge is to maintain economic activity while depreciating the dollar. In an influential proposal, Bergsten and Williamson (2004) argue that there must be revaluation of Asian currencies for dollar depreciation to be effective in curbing the American CAD.5 However, they argue that a concerted revaluation by these countries would not result in much appreciation relative to the dollar because of the high share of trade among themselves. Individual countries, especially China, would not engage in isolated revaluation because of loss of competitiveness relative to other Asian countries. Groups of countries, such as the G7 and G20, would not include all countries. The IMF could organize such an effort of country realignment. Exchange rate policy requires demand restraint in the United States and growth in demand in other countries, according to Bergsten and Williamson. Neither exchange rate policy alone nor demand policy without changes in relative prices would be effective. Summers (2004a) outlines policies that could avoid possible adverse circumstances in the future. A first step is to recognize the existence of the problem. Policy coordination would not work within the G7 because many of the concerns are with currencies outside that forum. A necessary condition would be the increase in national savings in the United States. In addition, there would have to be changes in relative prices to adjust the United States trade account. There would have to be coordinated adjustment of exchange rates that are fixed or under managed float. According to Summers (2004b), increasing national savings in the United States should occur by reducing the fiscal deficit. Adjustment of the CAD should occur with future growth of output faster than demand. Simultaneously, there is need for demand to grow faster than output in Europe and Japan. The United States has experienced a

32 The Global Recession Risk

period of import-led growth that must now change to a period of export-led growth. According to Kim (2005), there is no mechanism to coordinate exchange rate policies of Japan, China and Korea. Thus, none of these countries is willing to take the first step toward appreciation of their currencies. Kim proposes a global stabilization forum consisting of the G8 plus China and Korea. A meeting of this “G10” could begin the effort to coordinate policies to reduce global imbalances. Bergsten (2004) is concerned with potential disruption of the United States CAD following an overshooting of dollar depreciation that could increase interest rates and crash equities. He identifies low savings rates as the main cause of the CAD. The United States does not have instruments to increase national savings. However, it can adopt a policy of adjustment of the fiscal deficit that would have similar results as increasing savings in reducing the CAD. With credible fiscal policy, the United States could influence European countries to implement structural reforms and adopt policies of rapid growth that would compensate lower trade surpluses and revaluation of their currencies. There are benefits to China in changing its exchange rate policy, according to Bergsten. Appreciation of the CNY would reduce export growth, cool the overheated economy, control inflationary pressure and permit monetary policy by curbing the inflow of speculative capital. Bergsten sees room for an independent exchange rate policy by China in the form of a “one-shot revaluation” instead of pressures for floating by the United States and the IMF. There must be reversal of current imbalances in income and consumption, as argued by Roubini and Setser (2004). Income in the United States must grow faster than consumption with net exports providing the engine of growth of the United States. As counterpart for success, the rest of the world, especially emerging Asia, must provide a surplus of demand to maintain American growth. The proposal by Roubini and Setser consists of a policy mix that involves countries and regions. The United States must proceed with fiscal adjustment to avoid using foreign savings. Rapidly growing countries in East Asia must revalue their currencies to provide demand for external adjustment of the United States. Adjustment by China is critical because of its large relative size in East Asia. China must revalue its currency even to the point of running a modest current account deficit, which is typical of emerging countries. Cooper (2004) disputes the conventional wisdom that the United States CAD is not sustainable and that it should be lowered by deliberate

Policy Contributions 33

policy or financial crisis. He argues that the trend in the United States is 3 percent of real GDP growth and inflation of 2 percent. Assuming a stable CAD of $500 billion a year and 5 percent growth, the ratio of NIIP/GDP would rise until peaking at 46 percent in 15–16 years, declining subsequently. Cooper observes the common argument that the United States CAD reflects a deficiency of savings relative to investment. However, he argues that there is an opposite excess of savings relative to investment in the rest of the world. Cooper contends that any attempt to curb the United States CAD by other than an unlikely increase in investment abroad would certainly result in a world recession. There is a current of thought dividing the world in a center and a periphery. Dooley, Folkerts-Landau and Garber (2003, 2004) interpret the old Bretton Woods system after World War II as having the United States as the center and Europe and Japan as the periphery. The United States did not have controls on capital or goods markets. Europe and Japan functioned with undervalued currencies, controls on capital and trade, reserve accumulation and use of the United States as credible center of financial intermediation. The United States financed the “periphery” with mostly FDI. Dooley et al. interpret this system as a development strategy of export-led growth. Eventually, the periphery ascended to the center, adopting free markets and freer flows of capital and trade, causing the collapse of the system of fixed exchange rates of the Bretton Woods agreement. Dooley et al. argue that current Asian countries operate within a revived Bretton Woods system. Once again, it is a development strategy of export-led growth based on undervalued exchange rates. The United States is again the center of financial intermediation and the dollar the reserve currency of other countries. Maximization of the value of reserves is secondary to the objective of building a more efficient capital stock through export-led growth. Competition in international markets forces increasing efficiency of that capital stock. Capital controls are required to prevent residents of the periphery from offsetting investment decisions of the authorities. The model results in rising wages in the export sector, ensuring its political sustainability. Dooley et al. contend that the depreciation of the dollar against European currencies following increasing current account deficits has not resulted in rising yields and financing charges. They argue that the international financial system does not consist of fluctuating currencies and open capital markets. There is a Revived Bretton Woods with the United States as the center and Asia as the periphery. Europe faces difficult macroeconomic adjustment to this reality.

34 The Global Recession Risk

According to Dooley et al., the growing current account deficit of the United States has been financed by official inflows from Asian countries and private inflows from Europe. The current account of the United States has been driving economic growth in the world. Some of the Asian countries fix their exchange rates while others adopt managed floats. However, all these new “periphery” countries accumulate large reserves in dollars. Dooley et al. argue that the Revived Bretton Woods system is sustainable. Asian countries will prevent appreciation by accumulating more United States securities with low returns. They do not see major hurdles in increasing protectionism in the United States. Within Asian countries, pools of labor are extraordinary, with 40 percent of the Chinese population still awaiting transfer from farming. They conclude that overheating and possible inflation may still be well in the future. There is concern that investors may exit the United States because of the expected negative return of low yields and depreciation of the dollar. Dooley et al. argue that if regions such as Europe exit the United States, their currencies will appreciate relative to the dollar. The United States and Asia would run trade surpluses with Europe in proportion to the desired capital repatriation. There are several emerging countries that float relative to the dollar, especially Mexico, Brazil and Argentina. These countries could have the same experience as Europe. If their currencies appreciate relative to the dollar, their exports could be replaced by Asian products. Dooley et al. suggest that those countries would be better off following the Asian model, limiting exchange rate changes relative to the dollar to promote exports. The tools to undervalue their currencies would include controls and taxes on capital inflows and intervention in currency markets to undervalue the national currency relative to the dollar. Roubini and Setser (2004) contend that Bretton Woods II will not be stable because of various factors: • Adverse impact on import-competing sectors in the United States • Depreciation of the dollar versus European currencies causing loss of competitiveness of European countries • Increasing pains in China of foreign exchange intervention in the form of lack of control of money • Increasing financial risks for investors in United States assets resulting from depreciation of the dollar • Possible diversification of reserve investment away from the United States

Policy Contributions 35

The term “conflicted virtue” is assigned by McKinnon (2003) and McKinnon and Schnabl (2004) to the fact that under the world dollar standard, creditor countries in Asia cannot lend in their currencies. As a result, these creditor countries have the risk of currency appreciation and deflation. Appreciation for an individual country could result in loss of competitiveness in regional and world markets. In export-led growth models of Asia, this appreciation would result in lower production and employment. Other emerging markets have the problem of “original sin,” of Eichengreen and Hausmann (1999), of not being able to borrow in their own currencies. The United State borrows in its own currency, the dollar, thus being free of currency risk. McKinnon proposes a set of rules to alleviate this asymmetry of risks. McKinnon and Schnabl argue that high savings rates in East Asian countries force them into current account surpluses with the United States that has low savings rates. The asymmetry of dollar standard risks provides the United States an almost unlimited supply of credit in dollars. East Asian countries are locked into running current account surpluses. McKinnon and Schnabl concur with the Revived Bretton Woods that large current account surpluses in East Asia and the large CAD in the United States are sustainable or at least not about to cause a major disruption. They point out that the regime has existed since the early 1980s with Japan providing the current role of East Asia. The managed float relative to the dollar anchors domestic inflation in individual countries with benefits to neighbors connected by trade. They consider these benefits to be a “virtuous circle.” There is a common error of interpretation of both systems of Bretton Woods found by Eichengreen (2004b). The analysis by Dooley et al. requires that individual countries in Asia abandon their national interest for the collective interest of supporting all their currencies relative to the dollar. Coordinated action may fail when it is most needed to ensure survival of the system. In fact, current Asian countries do not have the tradition and institutions for collective action similar to those in Europe. Moreover, without capital controls, monetary authorities find substantial difficulty in sterilizing growth of reserves. Asian countries undervalue and promote high savings to channel resources to production of traded goods. However, they may be unable to prevent savings from financing non-traded goods. The World Economic Outlook of the IMF for September 2005 has new contributions to the analysis and policies for solving global imbalances. According to Laxton and Milesi-Ferretti (2005), the deterioration of the United States CAD is the counterpart to improvement of the

36 The Global Recession Risk

current account balances of emerging Asia, oil-producing developing countries and by lower magnitude small industrial countries. The current account of the euro area has been nearly in balance with surpluses in some countries such as Germany and deficits in others. These authors project continuing 6 percent ratio of the CAD to GDP and worsening of the NIIP of the United States that would reach 50 percent of GDP in 2010. Laxton and Milesi-Ferretti (2005) observe that a real effective appreciation of the dollar of 35 percent between 1995 and 2002 accompanied the deterioration of the US CAD. The dollar has depreciated by 12 percent since 2002 but mostly relative to the euro and industrial countries. Thus, the depreciation of the dollar has compensated for only about a third of the earlier appreciation. The Global Economy Model (GEM) of the IMF is used by Laxton and Milesi-Ferretti to analyze how the adjustment of the US CAD will occur. In the baseline or benign scenario, the US fiscal deficit remains at around 4 percent of GDP. This scenario assumes that there is no risk premium required by foreigners to continue to fund the US CAD. There is an additional depreciation of the dollar by 15 percent and decline of the CAD to 3.5 percent of GDP with slowing economic growth. The NIIP reaches 70 percent of GDP at some point in the future. A decline in the surplus of Asian countries explains most of the adjustment of the US without major impact on Japan and the euro area. Adjustment in the second scenario begins with a decline in the demand for US assets, causing sharp depreciation of the dollar and an abandoning of the exchange rate peg by Asian countries. The US would experience a significant trade surplus and contraction of economic activity. The depreciation of the dollar would generate inflation expectations in the US, causing an increase in interest rates with further adverse effects on economic activity. There would be currency appreciation, deterioration in trade and current account and slowing economic activity in emerging Asia. Laxton and Milesi-Ferretti provide suggestions on various regional policies that could facilitate the adjustment to the global imbalances. The essence of policy in the United States would be to increase national savings using fiscal consolidation as the main instrument. The target is to attain fiscal balance of the budget, excluding social security, by 2013. There would be reform of entitlements to ensure long-run fiscal sustainability. The fiscal consolidation of the United States would require both expenditure controls and a broadening of the tax base. China would use the new regime to promote further exchange rate

Policy Contributions 37

flexibility, which would facilitate greater flexibility in other regional currencies. Europe would have to increase growth and demand. In addition to recent structural reform, there would be improved product market competition and labor market competition and flexibility. Japan would increase growth and demand while carrying out essential structural reforms in agriculture, corporate and financial efficiency, labor market participation and flexibility. In the issue of the World Economic Outlook of the IMF for September 2005, Terrones and Gardarelli (2005) argue that the United States CAD aggravated because of an excess of investment over savings caused by fiscal policies that created a deficit and monetary policies of low interest rates that created the housing boom. In addition, there was an increase in investment during the recovery of the United States, worsening the excess of investment over savings. However, Terrones and Gardarelli observe that this view does not explain the continuing low level of interest rates in the world economy that should have increased because of higher investment. They attempt to solve this puzzle with an econometric analysis of 46 countries that generate 90 percent of world GDP. The emphasis is in identifying the factors of recent changes in savings and investment and the policies that could help alleviate the situation. They conclude that the imbalances in savings and investment were caused by various regional developments and that the solution will require policies by a number of countries. The data show global decline in savings and investment. This decline was deeper in the industrial countries that experienced a reduction in their share of global savings and investment from 85 percent in 1970 to 70 percent in 2005. Since 1997, industrial countries have experienced substantial reduction in their savings, especially in household savings. Simultaneously, the savings rate has increased in Asian and oil-exporting countries. In their charts, the decline in savings rates is faster than in investment rates in the United States, with a rising CAD, while the decline in savings rates is faster than investment rates in Japan, with a large current account surplus. The picture is more mixed in the euro area, with nearly equal rates of decline of savings and investment rates and a small current account surplus. Terrones and Gardarelli observe that the decline in nominal investment rates reflects various factors such as higher productivity because of innovations in technology such as in IT, capital deepening and productivity growth in producing sectors. The decline in investment rates is much lower when measured in volumes. It is valid to add to this qualification that the investment rates of over 40 percent in countries such as China increase

38 The Global Recession Risk

capacity in dubious economic activities because of regional politics; these investments may actually become future non-performing loans (NPLs). The econometric results of Terrones and Gardarelli show positive association between savings and GDP growth and fiscal consolidation. There is negative association between savings and increases in private sector credit and population ageing. There is positive association between investment and GDP growth and availability of credit but inverse association with the cost of capital. In the industrial countries, availability of credit explains more than one-third of the decline in savings in the United States. The decline of public savings is important in explaining the decline of savings in the United States and Japan. Population ageing is an important factor of the decline of savings in Japan. In the industrial countries, savings and investment have been driven by common events in credit/asset prices and output growth/ productivity. The increase in public sector saving has been important in China and in the oil-producing countries as well as the increase in output growth. In contrast with the 1980s, the current imbalances are more distributed among various regions in the world. Simulations show that an increase of 1 percent in the national gross savings rate in the United States would improve the CAD by 0.5 percent of GDP. Recovery of investment in non-China Asian countries would significantly contribute to reducing their surpluses. The revival of economic growth in the euro area and Japan would also contribute to adjust the United States CAD.

Financial flows There is another set of analysis and resulting policy proposals that emphasizes the globalization of financial flows, increases in productivity in the United States and the role of the dollar as an international reserve. There is initial discussion below of some empirical analysis of the CAD adjustment in industrial countries followed by these different interpretations and analyses. The scenarios of “disorderly correction,” according to Croke et al. (2005), describe the CAD adjustment by profound depreciation of the dollar with a run on the bond market, in the form of increases in interest rates and crash in the stock market, with resulting declines in equity prices. A disorderly correction would threaten the economic growth of the United States and possibly of the rest of the world. Croke

Policy Contributions 39

et al. warn that interest rates would increase even if there is smooth adjustment because higher export activity would be compensated by lower domestic consumption and investment. The conventional wisdom consists of a set of policies designed to strike preemptively the disorderly correction of global imbalances. The authors considered 23 cases of CAD adjustment of industrial countries over a period of 30 years. They analyzed the sample as a whole and into two groups: an expansion group with the seven best cases of GDP growth and a contraction group with the seven worst cases of GDP performance. The results are shown in Table 1.2. The authors warn that they did not test the theory of disorderly correction, partly because it does not have testable specifications. Their more modest approach was to examine the current account adjustment of industrial countries to verify if there were empirical regularities similar to those of the disorderly correction. The CAD adjustment of industrial countries has not

Table 1.2

Summary of results by Croke et al. (2005)

Indicator

Total Sample

Contraction Group

Expansion Group

Inflation

No evidence

Increase but no surge

Steady decline

Real exchange Moderate (8%) rate

Unchanged

Depreciation

Interest rates

Up before, then down and stable

Up before, down after Up before, down Long-term rise after before then down Long-term rise then before down

Stock market price

Down before, Decline before then then flat, then up decline and rebound

Decline before then increase

Savings/ investment

Both decline before and after, but investment more

Investments > Savings rates then adjust with decline of investment

Both decline before then adjust with both higher savings, lower investments

Real imports/ exports

Exports pick up after, adjust via imports

Export growth then adjust via imports

Export growth then less adjust via imports

Budget balance

Widen before, then Tighten

Surpluses rising then declining

Increase in deficits then balance

NIIP

Average 18% of GDP, flat in adjust

Worsens

Stable

40 The Global Recession Risk

been characterized by empirical regularities of inflation, interest rate increases and collapse of equity prices similar to those of a disorderly adjustment. Naturally, these findings do not preclude the existence of such a correction. They merely indicate that such a phenomenon has not occurred over a large number of countries in the past 30 years. Croke et al. found positive correlation between exchange rate depreciation and real economic growth. Moreover, there was positive correlation between long-term interest rates and economic growth, contradicting the disorderly description of lower growth because of increases in long-term interest rates. Apparently, higher GDP growth caused increases in long-term rates after the adjustment began. Finally, there is no correlation between the NIIP and the change in GDP growth. There is still a possibility of recession in the sample used by the authors. In the seven contraction cases, median fourth quarter GDP growth was 1 percent in the first year after adjustment began and 1 – 2 percent in the second year. However, the economies were overheated, with actual output moving toward potential while the CAD worsened. An earlier study at the FRB of the CAD adjustment of industrial countries, Freund (2000), found relatively low costs of adjustment: • moderate depreciation of the exchange rate • peak of the interest rate before adjustment and subsequent decline • improvement of the current account by decline of investment rather than increase of savings • slowdown of GDP growth but not contraction Freund and Warnock (2005) researched 26 current account reversals in 1980–2003 in a variety of industrial countries, defined as high-income Organization for Economic Co-operation and Development (OECD) members. Their objective is to determine if the effects of current account reversals depend on characteristics of the CAD: • • • •

size and persistence size and composition of financing openness of the economy use for consumption or investment

They assess how these characteristics affect the impact of the reversal in the form of currency depreciation, slowdown of GDP growth and improvement of the current account. Their results are summarized in

Policy Contributions 41

Table 1.3 and do not show a clear case for regularities similar to those in the disorderly correction. Freund and Warnock apply their analysis to the adjustment of the CAD of the United States after 2004. They conclude that the dollar would have to depreciate by 17 percent from its peak and that GDP growth would decline. There is an analysis of the impact of the budget balance and productivity shocks in the determination of the current account by Bussière et al. (2005). They derive a reduced form equation expressing the changes in the real current account as a function of global and country-specific shocks, changes in the primary budget balance and past investment. Using a sample of 21 OECD countries, they measure a minor effect of 10 percent of the budget balance on the current account. There appears to be a policy conclusion that reducing the budget deficit may not be sufficient to reduce the CAD. An econometric study of the FRB by Erceg et al. (2005) measures the impact of expansionary fiscal policy on the trade deficit. The authors consider the effects of a deteriorating fiscal balance in the United States originating in higher government consumption and a reduction in the labor income tax. According to their measurements, an increase of 1 percentage point in the share of government spending in GDP causes the ratio of the trade balance to GDP to worsen by less than 0.2 percentage point after 2–3 years. A decrease in the labor income tax that induces deterioration in the fiscal balance of 1 percentage point of GDP also has a negligible worsening of 0.2 percentage-point on the trade/GDP ratio. In the assumption that the United States fiscal deficit increases by 5 percentage points because mostly of policy shocks, the resulting trade deficit would amount to 1 percent of GDP.

Table 1.3

Results of Freund and Warnock (2005)

Characteristic

Depreciation

GDP Growth

Interest Rates/Equities

CAD size NFA size Openness Consumption Investment

Less No relation No relation More Less

Lower No relation No relation Unclear Lower

No relation No relation No relation No relation No relation

Financing type: Bonds FDI

No relation No relation

No relation No relation

↑rates ↓equities Not measured

42 The Global Recession Risk

A study researched the current account adjustment of industrial countries in 28 cases occurring in 17 countries in 1974–2003 (Debelle and Galati (2005)). During adjustment, there was typically a significant reduction in the rate of economic growth together with exchange rate depreciation. Because there were no changes in the nature of capital flows, the study concludes that the adjustment is an endogenous phenomenon. The adjustment is triggered by the resolution of domestic imbalances, in response to an international shock. In an exogenous shock, the CAD itself would force adjustment of the domestic economy and the exchange rate. Industrial countries have deep and liquid financial markets. Moreover, they can issue liabilities in their own currency. Thus, adjustment in industrial countries may occur more through changes in exchange rates and in quantities. Debelle and Galati identify a threshold of the CAD of 4–5 percent of GDP for initiation of adjustment. There is no identifiable threshold for adjustment in the ratio of the NIIP to GDP. The real exchange rate depreciated by only 4 percent during the adjustment. There is a J curve effect in the form of depreciation beginning two years before adjustment and continuing for another year, with initial limited improvement in the trade account. There was lower GDP growth, by about 2 percentage points, with recovery after the adjustment. Investment declined at the peak in the CAD and in the following three years. There is no evidence that the improvement in the fiscal deficit contributed to the CAD adjustment. Inflation declined during the CAD adjustment. Interest rates rose in response to the tightening and then declined. There is a key difference between industrial and emerging countries. There is no evidence of capital flight for industrial countries. Moreover, there was no internal financial crisis. Empirical research uses internal determinants of the current account such as the real exchange rate, output growth and the fiscal position. The external or exogenous determinants are global growth and interest rates. Domestic factors and international factors influence the CAD above the 2 percent threshold. Large CADs do not cause adjustment by themselves. There are important differences in the United States, according to Debelle and Galati. The US dollar is the major international reserve currency. Thus, wealth effects of depreciation of the dollar are spread throughout the world. In emerging countries, the CAD adjustment causes depreciation that has adverse impact on holders of liabilities in

Policy Contributions 43

foreign currency. This is not the case in the United States. In fact, the analysis of emerging crises laboriously explains the spread of an external crisis to the internal financial market. Finally, the United States earns a higher rate on its foreign-currency assets than on its dollar liabilities, resulting in positive net income. The US CAD rose from 1983 to a peak of 3.5 percent of GDP in 1987, partly as a result of growth of internal demand and a 50 percent appreciation of the dollar in 1980–85. Foreign investment in the United States increased. There was expectation of tightening monetary policy in the United States relative to easing in Germany and Japan. The deficit began to decline when it moved in the range of 3–4 percent of GDP. Economic growth declined together with depreciation of the exchange rate. The dollar declined by 35 percent in nominal terms and by 27 percent in real terms with contemporaneous appreciation of the mark and the yen. GDP growth declined in 1985 but remained steady in the following years. Adjustment occurred before the recession of 1991. The foreign liabilities of the United States are mostly denominated in dollars while the assets are in foreign currency. A depreciation of the dollar does not have an effect on the liabilities but increases the value of the assets. Thus, the ratio of net external liabilities to GDP did not change significantly. The assets of industrial countries are denominated in foreign currency while the liabilities are denominated in domestic currency, a point of departure of analysis by Lane and Milesi-Ferretti (2005). A depreciation of the exchange rate would raise the domestic-currency rate of return on external assets, improving the net foreign asset position. In emerging markets, assets are typically denominated in domestic currency and liabilities in foreign currency. Thus, depreciation causes an increase in the domestic currency cost of liabilities. In general, different changes in asset prices, such as equities, separate returns on foreign assets and liabilities. In 2001–04, the United States experienced trade deficits of 5 percent of GDP on average but the cumulative increase in its external liabilities was only 1.5 percent. Capital gains of 10 percent explain most of this phenomenon. Although the United States was a net debtor, net investment receipts were positive. At the same time, capital losses deteriorated the external accounts of Canada and the United States. Lane and Milesi-Ferretti conclude that the returns on foreign assets of the United States have consistently exceeded payments on foreign

44 The Global Recession Risk

liabilities. They measure that real dollar returns on foreign investment in the United States have been negative in 2000–04. Capital flows into the United States shifted away from equities toward low-yielding fixed rate debt. They believe that there could be a decline in demand for United States liabilities in an uncertain future time. The United States has enjoyed in the past few years the stabilizing effect of favorable returns on its net external position. However, exchange rate depreciation could eventually generate inflation expectations that could be incorporated in interest rate differentials. Large United States trade deficits are unsustainable and there is need for global adjustment in the form of rebalancing savings and investment flows between the United States and the rest of the world. Gourinchas and Rey (2005) use a phrase attributed to Charles Degaulle, “exorbitant privilege,” which actually originated from his finance minister Valéry Giscard D’Estaing, to characterize the exceptional position of the United States in international finance. In the 1960s, the French claimed that the United States had a privilege in borrowing short-term by issuing dollars held by central banks to run large investment surpluses. In the scholarly view, England became the banker of the world, borrowing short-term and lending at long and intermediate terms, financing capital in the world economy. The United States replaced England as banker of the world. In the recent deepening and integration of global financial markets, the United States has become the venture capitalist of the world, issuing short-term fixed-income liabilities and investing in equity and direct investment abroad. These authors argue that the United States has enjoyed an excess return on its net external positions from as far back as the 1950s. This external position is equivalent to a portfolio in which the country is short in domestic assets and long in foreign assets. A depreciation of the dollar can create a capital gain on this position. Gourinchas and Rey illustrate this possibility with data for December 2004, when the external assets of the United States reached $10 trillion (85 percent of GDP) and the liabilities $12.5 trillion (107 percent of GDP) for net foreign assets of –$2.5 trillion (22 percent of GDP). While 70 percent of assets are denominated in foreign currency, liabilities are all in domestic currency, the dollar. Thus, depreciation of the dollar can create a transfer of income of several percentage points of GDP from foreign countries to the United States. The authors consider two effects in the excess return of assets over liabilities of the United States. The return effect consists of higher returns within each asset class. There is a composition effect originating

Policy Contributions 45

in a higher proportion of low-yielding liabilities, which are assets to foreigners. The authors provide a decomposition of the excess return, or exorbitant privilege, of the United States into return and composition effects for the post-war period. They calculated market values for each asset and liability for the United States since 1952 to measure the net foreign asset position. The United States moved from a net creditor of 15 percent of GDP in 1952 to a net debtor of 26 percent in 2004. The change from creditor to debtor occurred in 1988. The current account is measured at historical cost. The valuation component is defined as the difference between the net foreign asset position valued at market prices and the sum of the current account. While the United States was a net creditor, the valuation component was positive, shifting to negative after becoming a net debtor. The authors conclude that the valuation component helped to stabilize the net foreign asset position of the United States, compensating for changes in the current account. The valuation component increased during periods of dollar depreciation and disappeared during appreciation. Moreover, the yield on the net foreign asset position of the United States has remained positive throughout the period of observation. After 1973, the average total asset return, including capital gains, is 6.82 percent of GDP, compared with a total liability return of 3.5 percent, for an excess return of 3.32 percent. There could be a point where the leverage of the United States, measured by the ratio of liabilities to assets, could result in net payments to foreigners. There is an analogy between the United States and a venture capitalist. The composition of American external assets evolved away from bank loans toward direct investment and equity. Simultaneously, American external liabilities concentrated in bank loans, trade finance and debt. Over decades, the leverage ratio of the United States increased significantly, rising above 1.3 recently. As a venture capitalist, the United States uses the credit status of its currency to borrow cheaply to invest in risky assets. Gourinchas and Rey argue that a depreciation of the dollar has two beneficial effects on the CAD: an increase in net exports and an increase in the net external asset value. This benefit derives from the reserve currency status of the dollar. However, Gourinchas and Rey define the “tipping point” when the ratio of gross liabilities to gross assets results in negative net asset returns. That is, the tipping point is the ratio of L/A when r(a)A – r(l)L < 0

1.2

46 The Global Recession Risk

where A is gross assets, L gross liabilities, r(a) nominal return on assets and r(l) nominal return on liabilities. The tipping point has increased continuously: 0.3 in 1952, 0.73 in 1973, 1.09 in 1991 and 1.34 in 2004. The exorbitant privilege acts to reduce significantly the magnitude of the depreciation of the dollar required to adjust the CAD. However, Gourinchas and Rey affirm that the United States is reaching the point when net asset income may become negative. Adverse expectations could develop in financial markets about the sustainability of continuing borrowing by the United States. Thus, the authors argue that investors in dollar assets may shift to other currencies, requiring a much higher premium on dollar assets because of perception of risk. They fear that there would be substantial depreciation of the dollar, a rise in rates and yields and possibly a global recession. There are econometric estimates of the thresholds of current account adjustment in G7 countries by Clarida et al. (2005). The thresholds of the United States, in particular for deficit adjustment, were much wider than for other countries and the speed of adjustment slower after crossing the thresholds. In addition, the CAD has exceeded for many years the threshold of adjustment by a large magnitude. They consider two alternatives. The United States CAD could be sustainable. In a second alternative, the authors identify current unusual factors that could slow adjustment: • Low international real interest rates. Current low real interest rates would encourage investment while discouraging savings • Slower and discontinuous depreciation of the dollar. In contrast with the experience during the late 1980s, the dollar has depreciated in lower magnitude and more sporadically • Exorbitant privilege. There is excess return of the United States on received relative to paid interest, dividends and profits of its gross assets relative to gross liabilities • Compensatory effects of dollar depreciation on the foreign liability position. For example, in 2003, the depreciation of the dollar compensated for 80 percent of the CAD According to the Gourinchas-Rey exorbitant privilege argument, a real depreciation of the dollar reduces the gap between the value of external liabilities of the United States, denominated mostly in dollars, relative to the external assets, 70 percent of which are denominated in foreign currencies. This avenue of adjustment reduces the market value of the difference between claims against the United States by foreigners and claims by the United States on foreigners. However, they point to

Policy Contributions 47

the terms of trade deterioration resulting from real exchange rate depreciation analyzed by Obstfeld and Rogoff, which reduces the real purchasing power of the United States. The adjustment of the CAD requires a shift of production from non-traded to traded goods and services. Clarida et al. obtained new data from the Commerce Department with revaluation of gross assets and liabilities by depreciation and price changes. The data permit insights into the exorbitant privilege arguments. The data for 2003 illustrate the compensatory effect of depreciation and asset price changes:

Trillions of dollars Gross external assets Gross external liabilities Net external liabilities Net capital inflow Increase of net external liabilities Increase of external assets by depreciation Actual value of net external liabilities

6.6 9.2 2.6 0.546 3.1 0.398 2.7

Because of the compensatory effects of depreciation of gross external assets, the net capital inflow of $546 billion originating in the CAD actually increased net external liabilities by only $100 billion. Using mark to market data, Clarida et al. show the importance of the revaluation of net external liabilities in other periods. Exchange rate valuation compensated 40 percent of the capital inflow in 2002 and 52 percent in 1994 and 1995. There are important changes in the portfolio composition of the United States identified by Clarida et al. Recently, 60 percent of United States gross external assets are invested in foreign equities and direct investment, while only 40 percent of foreign assets in the United States are in equities and direct investment. The United States enjoys a net premium on riskier net assets in equities and direct investment. In fact, Clarida et al. measure the returns on FDI by the United States at market values as follows:

Return on US FDI Assets Return on Foreign FDI Assets

2003

2004

%

%

8.7 3.4

9.2 4.3

48 The Global Recession Risk

The market value data contributed by Commerce show that the United States has enjoyed a higher return on FDI assets than the return paid on foreigners’ FDI assets since 1989, when United States net foreign assets became negative. Clarida et al. show that the decline of the dollar in the adjustment of the late 1980s amounted to 30 percent. Intervention by Asian central banks has limited the depreciation of the dollar to 15 percent since the peak in 2002. The current macroeconomic analysis of open economies builds models from its micro foundations. The national accounts define the current account as savings less investment. Economic units make their decisions on savings in terms of expected income over long periods and investment decisions on returns of projects. Thus, savings and investment are intertemporal phenomena, which is then also the case of the current account. Obstfeld and Rogoff (1996) argue that changes in savings should impact the current account at the margin. However, Edwards (2004) quotes empirical research showing that the measured coefficient of savings in the current account is 0.25, much lower than the theoretical 1. Moreover, empirical research shows relatively weak performance of the intertemporal model. Recent research amends the theory by incorporating portfolio decisions, reducing the disparity between theory and reality. Savers may evaluate risks and returns, allocating only a portion of their savings to foreign assets. Thus, changes in savings do not have a proportionate effect in the current account. A promising avenue is to analyze the behavior of a country’s net foreign assets. Edwards (2004) analyzed empirically the largest current account sample available, covering all types of countries in all regions of the world. Surprisingly, the median balance was a deficit for all regions and all countries. More than one-half of the countries had CADs in excess of 3.1 percent of GDP in the complete period 1970–2001. The third quartile shows a CAD of 7.2 percent of GDP. The lowest quartile corresponded to industrial countries with a deficit of 3 percent of GDP. There were 2732 CADs and 923 surpluses in the 3655 country-year observations. The number of deficit countries exceeded that of surplus countries for the entire period of analysis and for all regions. Because deficits and surpluses add up to zero, some of the surplus countries had relatively large surpluses. According to the portfolio theory used by Edwards, countries may show temporary deviations from their long-term sustainable current account. After a deviation reaches a barrier level, there is a tendency for return to the sustainable current account. Thus, there would not be

Policy Contributions 49

persistent current account imbalances. The data indicate an asymmetric pattern: current account surpluses tend to be more persistent than CADs. The sample shows a high probability that countries reversing the CAD experience a currency crisis. There is a lower impact of the CAD reversal on growth and employment in countries that are more open to trade and in countries with flexible exchange rate regimes. Countries reversing the CAD have a stronger impact on GDP than just merely the effect on investment. There is no statistically significant relation between CAD reversal and domestic banking crises. There is value in the productivity approach to the CAD, according to Ferguson (2005). The near doubling of productivity in the United States after 1995 raised the returns on investment, attracting foreign capital. In addition, as Ferguson argues, there was a flattening of domestic demand in areas such as Japan and Europe, increasing the capital available to the United States. Japan and the euro area have experienced growing current account surpluses together with low GDP growth. Weaker demand in Japan and the euro area reduces the sales potential of the United States and increases foreign savings that can be invested in the US. Moreover, weaker net exports reduce domestic interest rates, raising consumption and investment. In addition, there have been growing current account surpluses of the developing countries with the United States. There has been a reduction in home bias, or the propensity to invest in the home country, which together with improved financial intermediation has increased the availability of foreign capital to the United States. The reduction of the United States fiscal deficit may contribute to adjustment by releasing resources for private investment. The adjustment of the CAD may occur through the private sector. The CAD did not originate primarily in economic events in the United States but rather in changes in the global economy, as observed by Bernanke (2005). Various factors created a global savings glut, explaining the United States CAD and the fall in long-term interest rates. The expectation of the rise in retirees relative to workers in major industrial countries drives the rise in global savings. The excess of payments to foreigners relative to payments received from foreigners is the CAD, resulting in borrowing from abroad. There is an argument that the deficit originates in the reduction of competitiveness of the United States in world markets, unfair competition by low-wage countries with undervalued exchange rates and changes in trade policy. These factors alone do not explain such a large, fast-growing CAD.

50 The Global Recession Risk

A country’s national savings is equal to household savings plus corporate savings less the budget deficit. National savings would equal investment in a closed economy. In an open economy, investment can exceed national savings because of the opportunity to borrow abroad. The CAD is the excess of payments abroad over receipts from foreigners. Thus, the CAD is the shortfall of national savings over investment. The low savings argument points to a decline in savings as a share of GDP from 18 percent in 1985 to 16 percent in 1995 and 14 percent in 2004. Thus, the low savings argument contends that the CAD problem originates in domestic imbalances in the United States. This argument ignores the explanation of why the savings/GDP ratio in the United States has declined. The “twin deficit” theory argues that the budget deficit in the United States is the origin and the cause of the acceleration of its CAD. There is a major inconsistency with the data. The CAD of the United States rose from 1.5 percent of GDP in 1995 to 4.2 percent in 2000, a period of fiscal surplus, in practice and in policy intention. The twin deficits theory also fails to explain why Japan and Germany show current account surpluses with significant budget deficits, especially in the case of Japan. Professor Bernanke argues that part of the explanation is in the savings glut of the past ten years. Many industrial countries experience the need to increase savings because of ageing population, retiring in the near future. In addition, these economies have high capital to labor ratios, resulting in diminishing attractiveness of opportunities for domestic investment. Mature industrial economies tend to run capital account surpluses because of the combination of high savings and less attractive returns on domestic investment. The United States CAD increased by $548 billion from 1996 to 2004 while the combined current account surplus of industrial countries declined by $441 billion. At the same time the developing countries moved from a combined deficit of $90 billion in 1996 to a surplus of $326 billion in 2004, a shift of $416 billion. Professor Bernanke believes that the emerging market crises of the 1990s caused a change of policy by developing countries to avoid CADs and risky domestic economic policies. Many of these countries followed new policies of becoming net exporters of financial capital. Current account surpluses became a source of generating large international reserves as a cushion for the crises of the 1990s. Bernanke argues that governments became financial intermediaries, issuing internal debt to channel domestic savings to international financial markets.

Policy Contributions 51

Bernanke points to important characteristics of the attractiveness of the United States for foreign capital: new technologies, increasing productivity, relatively no political risk, observance of property rights and adequate regulations. The glut in savings flowed into the United States, causing an appreciation of the dollar and financial assets such as equities and real estate. There are relative advantages in the equities markets in the United States: depth, liquidity, transparency, regulation and a legal system to solve disputes. A wealth effect in the form of rising equity prices and, subsequently, real estate values, together with the appreciation of the dollar caused increasing demand for cheaper imports. The appreciation of the dollar withdrew part of the competitiveness of exports of the United States in global markets. In a second stage, there was an incentive for rising real estate values. The global savings glut combined with lack of attractive investment opportunities caused a lowering of real rates of interest. Bernanke observed a decline in the implied real rate of interest in the ten-year inflation-indexed bonds from 4.3 percent in March 2000 to 1.8 percent in 2005, with comparable rates of 1.8 percent in the UK, 1.4 percent in France and 0.4 percent in Japan. Exceptionally low real rates of interest and effective financial intermediation combined to raise significantly real estate prices. As a result, the ratio of wealth to income of households in the United States is 5.4, above the average of 4.8 in 1960–2003. The continuing strength of investment in residential construction jointly with the initial recovery in business investment caused a shortfall in savings, leading to growing CADs. The channeling of foreign savings to the United States had a stronger impact on its CAD because its currency is widely used as international reserve and its Treasury securities are perceived as immune to default. Bernanke quotes a study at the FRB showing that a $1 reduction in the fiscal deficit reduces the trade deficit by only $0.20. Thus, eliminating the fiscal deficit would only reduce the CAD by 1 percentage point, relative to the target of 3–4 percentage points of GDP. The reduction of the fiscal deficit would lead to desirable downward pressure on interest rates, which would work in the way of preventing an improvement in the CAD by encouraging consumption and investment. The view of Bernanke is that external factors are more important in explaining the CAD than internal ones. An important policy effort could consist of showing developing countries that they should become borrowers instead of lenders of capital to invest in attractive domestic opportunities. The promotion of macroeconomic stability is essential to avoid the crises of the 1990s. It could be added that the

52 The Global Recession Risk

elimination of international moral hazard may be important in preventing those crises. Structural reforms are also quite important such as stronger property rights, standards and codes in bank regulation and supervision, transparency of economic information and removal of impediments to international capital flows. Macroeconomic stability and a better business environment would permit lower levels of precautionary international reserves. The ratio of official finance to the CAD is not meaningful, according to Taylor (2004). This ratio fluctuates significantly, from 92 percent in the first quarter of 2004 to 50 percent in the second quarter. However, financing of the CAD was smooth, volatility in markets was subdued and long-term interest rates declined. He also questions the measurement of required exchange rate changes to adjust the CAD because of the difficulty in modeling changes in many factors simultaneously. Taylor also warns that the higher propensity to import in the United State relative to other countries changes over time, as it was the case in Japan in the 1990s. Greenspan (2003) recognizes risks in the CAD/GDP ratio of the United States but believes the CAD may be resolved without major disruption. This has been the experience of developed countries 1980–2000 as documented in a study of the Federal Reserve Board (Freund (2000)). He also points out that with fully flexible flows of capital and labor, there has not been an interstate crisis in the United States even with fixed exchange rates among states. However, while international capital is more flexible, labor is inflexible. The world is also composed of relatively fixed exchange rates to the dollar, as in Asia, and flexible rates, as in the euro area. Greenspan proposes to restrain protectionism to ensure flexibility that eventually will reverse world imbalances. Nevertheless, Greenspan is concerned that a CAD/GDP ratio of 5 percent poses the threat of difficulty in financing a growing external debt. He has a different interpretation of the origins of the United States CAD or the negative net savings. There was an acceleration of productivity change in the United States in the mid-1990s that increased investment, equity prices, wealth and the expectations of future income. The result of this wealth effect was increasing consumption and lower savings. In the second half of the 1990s, government savings—driven by the impact of rising wealth on taxable income— restrained the gap between savings and investment. The new public deficit after 2002, while the economy struggled away from recession, worsened the savings/investment gap or CAD. Expectation of relatively

Policy Contributions 53

high returns in the United States after 2000 caused an increase in capital inflows. More recently, central banks accumulated large amounts of dollars, which contributed to financing the United States CAD. A higher propensity to import in the United States than in the rest of the world is a chronic structural constraint, which would cause trade deficits without changes in relative prices. When the rate of growth of the United States accelerated in the 1980s, the trade and current account deficits increased. It is difficult to measure the sustainability of the CAD, according to Greenspan. There is the much more difficult issue of when foreign residents will reverse capital flows to the United States. However, he warns that flows of borrowed funds to finance the growing CAD and the debt/GDP ratio may not be sustainable. The capacity to raise foreign debt is unknown and difficult to measure. According to Greenspan, worldwide financial deregulation diversified financial instruments and institutions. Managing risk in financial intermediation has improved significantly, thus permitting a rising ratio of gross external liabilities to trade. Because of continuing cost-reducing technology, he does not foresee an end to growth of financial intermediation. It would not have been feasible to finance a CAD/GDP ratio of 5 percent 20–30 years ago. That is why the CAD of the United States has not proved disruptive in the current boom of financial intermediation. In another work, Greenspan (2005) points to home bias, or the propensity to invest at home, as a factor of the ability of the United States to fund its investment abroad. The increase in productivity in the United States significantly improved its return on investment, contributing to the strength of the dollar in the late 1990s. Although the dollar has depreciated since 2002, exporters to the United States have maintained their exports, fearing a loss of market share. He argues that while the dollar rate versus the euro and sterling depreciated by 30 percent, prices of manufactured imports from the European Union to the United States increased by only 9 percent. For some time, exporters lowered their profit margins to maintain their share. At a point, exporters prefer to lose share than to sacrifice margins further. Greenspan explains the widening of the nominal trade deficit even with a decline of the dollar, since 2002, in terms of four additional factors: • The import/export ratio. Because of the legacy of an export/import ratio of 50 percent, exports must increase twice as rapidly as imports just to stabilize the trade deficit

54 The Global Recession Risk

• The differential propensities to trade. The propensity to import foreign goods in the United States is higher than the propensity to import US goods abroad • The higher relative growth rate in the United States. The US economy has been growing faster than those of its trading partners, accentuating the growth of imports relative to exports • The impact of commodity prices on imports. The increase in oil prices has caused rapid growth of US imports Taylor (2004) considers policies of the United States relative to the CAD. There is no exact relation between the CAD and fiscal balance in the United States. The decline of the CAD/GDP ratio was faster during the fiscal surplus of the late 1990s than during recent periods of tax cuts. Growth of the economy should again reduce the fiscal imbalance, contributing to reduction of the CAD/GDP ratio unless private savings and investments offset this effect. Policy should focus on reducing the fiscal deficit with growth of the economy and restraint of government spending. There are differences in estimates of the deficit by the administration and the CBO. The policy is to continue reducing the fiscal deficit as percent of GDP while encouraging savings for education, health and retirement. In addition, the administration is promoting policies to increase global growth. The G7 is encouraging structural, supply-oriented policies in Europe and Japan to increase productivity and employment. Efforts to increase trade flows could also improve the prospects for global growth. The United States and the G7 have emphasized market-based flexible exchange rates. The G7 meetings in Boca Raton and Washington encouraged this exchange rate flexibility to promote adjustment of imbalances in international finance. Taylor believes that the CNY is an anchor currency and its flexibility would spread to other currencies. The Administration is seeking cooperation with Chinese authorities to promote this flexibility. Balls and Giles (2005) report that Greenspan continued to show optimism that the combination of flexible markets and budget restraint will adjust market imbalances. He believes that the market will permit stability of the CAD and over the long-term reduce financing requirements. There are important favorable conditions in the world economy— productivity growth albeit concentrated in the US, tamed inflationary and risk expectations, integration of financial and economic markets

Policy Contributions 55

and diverging savings and investment—that constitute the background to understand global imbalances (Geithner (2006)). These favorable conditions would result in larger numbers of countries with surpluses and deficits and growing imbalances because flows would move to bring equality of savings and investment worldwide. Capital would pursue higher returns, tending to equalize savings and investments. There are many factors determining the imbalances, restraining the ability to explain them theoretically and measure them empirically. An important policy of attacking the imbalances and their threat of abrupt adjustment, according to Geithner, consists of reducing the US structural budget deficit. Fiscal consolidation may not necessarily reduce the imbalances but would raise confidence in American politicians to face the problem as well as provide a cushion for future adjustment. The US financial system should continue investing in risk management and controls, maintaining sufficient capital for an eventual shock on the dollar. The continuing open economy policy of the US should also ensure that the adjustment is benign, providing flexibility to adjust to shocks. Exchange rates that are tied to the dollar should become more flexible to avoid rigidities that could prevent adjustment.

2 China in Need of a New Paradigm

Introduction China has impressive dimensions. Its population is about 1.3 billion persons and its territory has an area of 9,561,000 square kilometers.6 However, its GDP per capita is still significantly lagging at an estimated $1700 in 2006. The rate of inflation declined from 3.9 percent in 2004 to about 2.1 percent in 2005 and is estimated at 2 percent in 2006. Real GDP growth was 9.5 percent in 2005, 9.3 percent in 2005 and is growing at 10.9 percent in mid-2006. The growth of China is driven by industrial production, which grew in percentages by 11.1 in 2004, 9.7 in 2005 and 17.7 percent in mid-2006. China is revising its national accounts to include smaller private activity. This revision raises its output by 17 percent and increases its past growth rates. Government expenditure is 22.2 percent of GDP and the budget is estimated to be in deficit in 2006 by 1.1 percent of GDP. China is a major presence in world trade. Its exports are estimated to reach $889 billion in 2006. However, only 20–30 percent of these exports consist of value actually added in China because of the high content of re-exports. The share of the United States in total Chinese exports is about 21 percent and the share in imports is 8 percent. However, 34 percent of Chinese exports are to Asian countries (17 percent to Hong Kong, 12.4 percent to Japan and 4.7 percent to South Korea). Chinese leaders desire to continue the policy of rapid economic growth of nearly two digits (McGregor (2005Nov7)). The driving political factor is the belief that China must create more than 20 million new jobs per year for new entrants in the job market and to absorb excess labor being displaced from agriculture. However, distortions of rapid growth are beginning to emerge. Thus, Chinese leaders desire to 56

China in Need of a New Paradigm 57

shift the source of growth away from investment and exports toward consumption. More efficient use of energy is another policy objective together with environmental controls. There are sources of conflict in China. The leaders do not desire to change the one-party rule and their control of society (McGregor (2005Nov7)). In fact, there has been pressure on the media, think tanks, analysts and a defiant civil society that is more vocal and aggressive in its protests. These repressive politics contradict the dynamism of the private sector, which is providing a significant part of the impulse for growth and greater productivity. The private companies account now for about two-thirds of the non-farm GDP. The OECD estimates that the number of state companies decreased from 300,000 in 1995 to 150,000 currently. Between 1998 and 2003, the number of local private companies tripled while the state sector increased by only 70 percent (McGregor (2005Nov7)). Banks provide about 90 percent of business financing in China. The banking system constitutes another hurdle of China in its desire to modernize and grow. Four large banks—Bank of China, Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China—account for almost all the banking business in China. In the past, these four banks have financed unsound projects of state companies. Thus, these banks have been plagued by bad loans. The eventual bailout of the banks constitutes a large future public deficit. China has to allow the entry of foreign banks by 2006 within its agreements with the World Trade Organization (WTO). According to Moody’s, the government has spent more than $430 billion in a series of bank bailouts since 1998 (Guerrera (2005)). The intention now is to allow the banks to find their own solution. Investors’ demand for shares in China’s big four banks is estimated at $80 billion. The hope is that foreign ownership will improve bank management. Prestigious banks and investment banks are participating in large Initial Public Offerings (IPOs) of Chinese banks. Chinese banks have been preparing for the IPOs and foreign ownership. There have been sharp reductions in staff and in the number of branch offices (Ridding (2005)). There has been an effort to improve corporate governance by replacing retired general managers in the board with independent directors. The growth of reserves of China and its large trade surpluses constitute important issues in the discussions and negotiations on global imbalances. Although export growth slowed while imports accelerated in the latter part of the year, the trade surplus of China tripled to $102 billion in 2005 from $32 billion in 2004 (McGregor (2006Jan11)).

58 The Global Recession Risk

The larger part of the surplus occurred in the first eight months of the year when exports were growing at 30 percent, almost twice as fast as imports. The trade surplus of China in the first half of 2006 was $61.45 billion, higher by 54 percent than in 2005 (Browne (2006)). The foreign exchange reserves of China are approaching $1 trillion by the end of 2006 compared with $168.9 billion in 2000. Chinese leaders see the export performance as the engine of domestic growth and employment, which are critical in a country that has more than 72,000 protests per year. US data show the bilateral surplus of China with the US at $200 billion. The accounting in US data of re-exports from Hong Kong as Chinese exports explains the discrepancy between Chinese and US measurements. The managing authority of foreign currency of China (State Administration of Foreign Exchange) announced in early January 2006 that it would diversify the “currency and asset structure” of its foreign exchange reserves to increase “investment returns” (Financial Times (2006Jan9)). However, officials of the central bank of China stated that the announcement of reserve diversification was a misunderstanding. The foreign exchange reserves of China reached about $890 billion at the end of 2005 and are estimated to increase to $1000 billion at the end of 2006. China will become the largest holder of foreign exchange reserves in the world, equivalent to about 40 percent of GDP. Dollar assets account for 75 percent of China’s reserves and are equivalent to around 30 percent of its GDP. The Financial Times (2006Jan9) informs that the ratios of reserves to GDP of Hong Kong, Malaysia, Singapore and Taiwan are even higher. There is no appealing economic argument for such large holdings of reserves and for further increases. These Asian countries are in an early emerging phase and it would be more opportune to borrow from abroad to increase their capital and productivity to optimize their longterm growth potential. There is a high opportunity cost in holding these reserves in terms of foregone investment and absorption of technology. There is an additional opportunity loss in returns on lowyielding securities of the United States. In addition, there is a high risk of depreciation of the dollar in an adjustment of the US CAD. However, China faces disadvantages in diversifying its reserves holdings away from dollar assets. There are not many alternative safe and liquid investments (Financial Times (2006Jan9)). Moreover, China cannot unload its high reserves in dollar assets without causing a capital loss on itself. The diversification away from dollar assets would sacrifice the policy of fixing the CNY to the dollar, forcing the author-

China in Need of a New Paradigm 59

ities to repurchase the dollars sold in diversifying its reserves with the objective of maintaining the dollar peg. Diversification would require a more flexible exchange rate. Slowing the accumulation of foreign exchange reserves would require an entirely different economic policy (Financial Times (2006Jan9)). The authorities would have to allow imports and purchases of foreign assets to prevent increases in reserves. The policy mix would require appreciation of the CNY, increasing domestic spending and freer decisions on imports and capital outflows. There are two key issues in the policy discussion of China. The first theme is the improvement of the efficiency of the Chinese economy. The first section below shows that there are two Chinese economies, one producing for the internal sector and another adding small value in re-exporting activities. In order to attain its desired ranking in prosperity in the world economy, China must address the inefficiency of its economy producing for the internal sector. The second issue is the management of the exchange rate of China. Some policy proposals advocate a major revaluation of the CNY by 15–40 percent. This revaluation would reduce the external imbalance of China. After all, China is an economy growing from low levels of income and should be importing instead of exporting capital. The IMF proposes the revaluation of the CNY on different arguments. The inflow of reserves prevents the management of monetary policy and distorts the role of interest rates in allocating resources to their most efficient use. The second section below focuses on the various approaches to the issue of revaluation.

The two Chinese economies There are actually two Chinese economies. The economy producing for the domestic market resembles that implemented in Brazil in the late 1970s. In fact, many of the principles, policies and effects are similar, only that Brazil overvalued the currency and discouraged exports. The basic idea was that Brazil needed to grow at 6 percent to absorb at least 1.5 million new entrants per year in the labor force. An even higher growth rate was required to move the underemployed to the more productive sector. The large domestic market, low level of per capita income and vast resource base would provide the market and resources for growing output. The government created numerous state-owned enterprises (SOE) in a few years. One of the projects, Nuclebrás, was an atomic energy company that never functioned properly but absorbed

60 The Global Recession Risk

$20 billion. The government provided large amounts of subsidized credit to develop basic industries such as steel and capital goods. Many of these companies did not honor their loans and did not complete the projects. The largest commercial bank, Banco do Brasil, was controlled by the government and had a historical role in financing deficits. There were state banks, development banks and state savings banks. Brazil implemented controls of interest rates, external capital and prices and numerous distortions of financial markets such as repressed prices of imported energy. The currency was depreciated periodically in a managed float using a “purchasing power parity” formula with weights by trade with major trading partners. The “basket” created major overvaluation relative to some trading partners, causing the loss of competitiveness. Because of high inflation, talent flowed to high-paid jobs in financial markets. In anticipation of future devaluation, there was under-invoicing of exports, over-invoicing of imports, price transfers by multinationals and anticipation of remittances of dividends, causing capital outflow. The mechanism that financed Brazil was not a Bretton Woods arrangement but rather money center banks. Banks based their credit decisions on emerging markets on the Wriston Doctrine, after Walter Wriston, Chairman of Citibank. According to this doctrine, a portfolio of loans to emerging markets mitigates credit risk because of diversification in debtors. Advised by technicians specialized in country risk analysis, hired away from the IMF and the World Bank, Citibank and other international banks believed that an individual country may experience difficulties but not all countries simultaneously. Gesualdo Constanzo, a former IMF officer, developed analysis of country risk at Citibank using forecasts of the balance of payments. Other banks imitated Citibank. Wriston wrote in the New York Times, on September 14, 1982, that countries may experience decline in financing but they never bankrupt.7 In 1977, positions of the largest nine banks in the United States in non-oil producing emerging markets totaled 188 percent in relation to capital.8 Positions in Brazil alone totaled 42 percent of capital, in Mexico 33 percent and in both countries combined 75 percent. In 1982, the exposure of those nine banks reached 235 percent of capital, with 46 percent in Brazil, 44 percent in Mexico and 90 percent in both countries combined. The Wriston Doctrine collapsed with the nearly simultaneous moratorium of Latin America and the Philippines. The credit error consisted in financing unsound balance of payments deficits, such as those of the debtors in the late 1970s. Forecasts of

China in Need of a New Paradigm 61

creditworthiness of countries proved as shaky as forecasts of corporate clients, in part because of asymmetry of information but also because of difficulty in forecasting financial variables such as the balance of payments. Argentina’s recent crisis raises doubt if the different forecasts and models of today really contribute to mitigate risk. There was generalized pessimism about the adjustment of Brazil after the debt crisis of 1983. In reality, Brazil adjusted rapidly and successfully. The current account deficit collapsed from $16.8 billion in 1982 to $6.8 billion in 1983 and nil in 1984. Growth of GDP was 0.8 percent in 1982, –2.9 percent in 1983, 5.4 percent in 1984 and above 7 percent in 1985 and 1986. Inflation remained at a high level. However, a major effort by authorities reduced the deficit and subsidies significantly. Adjustment consisted of export growth and import restraint, resulting in an increase of the trade surplus from $0.7 billion in 1982 to $13.1 billion in 1984. Brazil used trade policy and exchange rates to benefit from growing world output and trade. There is another Chinese economy that can be described as a gigantic maquiladora, a term defined in the dictionary as a foreign-owned factory in Mexico where low-paid workers assemble imported products for export. China has become the outsourcing center for other Asian countries by exporting products to China for “finishing touches.” These products are then re-exported to the industrial countries, mainly Europe and the United States. The label “made in China” is misleading and probably should read “finished in China.” The re-exporting economy is a more viable strategy. In fact, it was one of the first “development” strategies, postulated by Hirschman (1958). Eventually, China could modernize its productive structure with the technology and productivity increase irradiating from the “finishing touches” sector. However, the re-exporting economy can provide employment and progress to only a small fraction of the Chinese population. Chinese leaders do not believe that it would be sufficient to calm Malthusian fears and conflicts of power between the central and local governments. Table 2.1 shows macroeconomic indicators of the Chinese economy. What drives high growth in China is not the export economy but rather the high rate of capital formation in the economy producing for the internal market. Savings and investment account for 40 percent or more of GDP. The money supply grows at close to 20 percent, providing the liquidity for bank loans—the only form of intermediation—to finance production for the internal market. The current account surplus jumped from 1.7 percent of GDP in 2000 to about 7 percent in 2005–06. Reserves may reach $1.2 trillion in 2007.

62 The Global Recession Risk Table 2.1

Indicators of the Chinese economy

Δ% GDP Money CPI % GDP Deficit Savings Investment Current Account $ Billion Reserves

2000

2001

2002

2003

2004

2005

2006

8 12.3 0.4

7.5 14.8 0.7

8.3 19.7 –0.8

9.5 19.6 1.2

10.1 14.9 3.9

9.9 17.6 1.8

9.5 16 2

–3.3 38.2 36.3 1.7

–2.7 40 38.5 1.3

–3 43.1 40.3 2.4

–2.4 47.6 44.4 2.8

–1.5

–1.3

–1.1

3.6

7.1

6.9

168.9

216.3

409.2

615.5

292

824

1044

Source: IMF PIN No. 04/99, Aug 25, 04; PIN No. 05/122, Sep 12, 05; World Economic Outlook April 2006.

There are numerous signs of possible overheating of the economy of China. In the first seven months of 2005, industrial output increased by 16.3 percent relative to a year earlier. The growth of exports at 28.7 percent has been driving industrial output. Investment banks predicted growth of industrial output of around 15 percent for the year (Wu and Huo (2005Aug16)). The People’s Bank of China (PBC) allowed significant growth of the money supply before changes in the exchange rate regime. M2 increased by 16.3 percent in July relative to a year earlier, above the target of 15 percent. Loans increased by 13.1 percent and retail sales by 12.7 percent (Wu and Chan (2005)). Imports of crude oil in China continue to increase unaffected by the soaring price of oil. In July, crude imports increased by 15 percent relative to a year earlier. The increase in the first seven months of 2005 is 5.4 percent for a total of 74.49 metric tons. China imposes retail price controls to avoid the impact of oil price increases on consumers. The second largest oil refiner, PetroChina Co., experienced a loss of $734.2 million in the first half of 2005. Its average refining margin collapsed from $7.2 per barrel to $1.50 (Kai Pin (2005)). McCormack (2005b) observes that China has reserves of oil for 15 days compared with 90 days for the United States. China is vulnerable to increases in oil prices or disruptions of supplies. China abandoned most price controls in 1994. However, there are still price controls, or guidelines in pharmaceuticals, health care and education (Feyziogˇlu (2004)). The administrative prices have a weight of approximately 10–15 percent in the Consumer Price Index (CPI).

China in Need of a New Paradigm 63

The authorities decided to maintain some price controls because of fears of social unrest resulting from unemployment and underemployment. There are also repressed energy prices that will eventually be passed on to consumers and producers. Banking dominates financial intermediation in China (Barnett (2004)). Domestic and foreign currency loans amounted to CNY3 trillion in 2003 or 26 percent of GDP. The issue of bonds was only CNY36 billion, or 0.3 percent of GDP, and resources obtained through the stock market CNY136 billion, or 1 percent of GDP. China’s banking system is very large, state-owned and rapidly growing. The stock of bank loans reached 145 percent of GDP in 2003, one of the highest levels in the world. The state-owned commercial banks—Bank of China, Agricultural Bank of China, China Construction Bank and Industrial and Commercial Bank of China—account for two-thirds of bank assets, credit and deposits. Growth of savings by 40 percent per year and sterilization of reserve inflow cause double-digit growth of bank deposits, credit and assets. There is a major managerial challenge in improving risk management and governance in China’s banks. A significant part of the NPLs in state-owned commercial banks is credit to SOEs. According to official data, NPLs were 21 percent of GDP in 2003. The IMF and the People’s Republic of China (PRC) concurred on the need to proceed with banking reform to promote financial stability and to become competitive with foreign banks entering China after 2006 (International Monetary Fund (2004Jul6)). The authorities recapitalized the Bank of China and the China Construction Bank with $45 billion in 2003. The Fund argued that Chinese banks required improvements in management, corporate governance and risk management. The IMF advised that continuing liberalization of lending rates would improve bank management. Chinese authorities agreed that China must control recurrence of NPLs, tighten lending standards and bank supervision while reforming SOEs. In late 2004, the PBC increased interest rates for the first time in nine years and removed the ceiling on lending rates of banks (Dunaway and Prasad (2004)). In the earlier regime, banks could not lend at more 3 than 1 4 percent above the PBC basic lending rate. The change in interest rate policy could improve the pricing of credit risk by banks and increase lending to small and medium size enterprises (SME). While there may be significant risks in SMEs, they offer the most promising avenue for growth and job creation. Larger SOEs may be managed less efficiently and could result in much larger NPLs. Hopefully, there will

64 The Global Recession Risk

be an improvement in the management of credit risks of banks, resulting in intermediation of savings to truly productive activities. There have been several deals by foreign banks in Chinese banks (Linebaugh and Kissel (2005)). The deals by foreigners with Chinese banks totaled $15 billion in June–August 2005. Goldman Sachs, Allianz, Amex and others entered in a preliminary agreement to invest approximately $3 billion in the Industrial and Commercial Bank of China. Temasek, the Singapore fund, will invest $3 billion in the Bank of China and $1 billion in the China Construction Bank. A group led by the Royal Bank of Scotland has reached a deal to acquire $3.1 billion in the Bank of China. The dynamic economy of China, growing at 9 percent per year, and the potential of the Chinese consumer, starting at a low per capita income, $1000–2000, are the major motivations for this investment. Consumer loans are viewed as an important source of growth and profit. There is low penetration of credit cards in a population of 1.3 billion that is anxious for middle class status symbols such as cars and home ownership. The large commercial banks of China have more than 10,000 branches, affording a means of wide market penetration. There is significant risk in these investments. Chinese banks are plagued by corruption and theft. Recently, the former head of the unit of Bank of China in Hong Kong received a suspended death sentence for embezzlement. There have been many similar episodes. The banks have very low profitability and are quite vulnerable to a slowdown of the economy. The credit decision in the banks has not been sound in the past as they continued to fund new doubtful projects (McCormack (2005b)). While some economists believe there will not be a “landing” at all of China’s economy, others express concern as to whether it will be the rare soft landing or the disruptive hard landing. Based on analysis of China’s economy during the past 20 years, Goldstein and Lardy (2004) conclude that economic growth will decline by 4–5 percentage points from current levels. They argue that investment of 40 percent of GDP is not sustainable in China. The previous adjustment after 1993 extended over 4–6 years, with significant slowdown in investment. China could still continue to grow if exports or other sectors, such as consumption, compensate for the adjustment in investment. However, consumption and investment have been positively correlated in China. It is difficult to conceive that consumption could move in opposite direction and compensate for investment in maintaining growth. Government consumption is only one-third of GDP and is unlikely to compensate fully for a slowdown in investment.

China in Need of a New Paradigm 65

The economy of China continued to overheat in 2006. Table 2.2 shows the rate of GDP growth at almost 11 percent in the first half of the year. Investment in fixed assets grew by 29.8 percent, driving growth of the economy. Industry grew by an extremely high 17.7 percent and real estate investment by 24.2 percent. There is a non-zero probability of a hard landing.

Agriculture

Industry

Investment in Fixed Assets

Real Estate

Retail Sales

CPI

Exports

Imports

Urban Disposable Income

China, year-on-year growth rates, June 2006

GDP

Table 2.2

10.9

7.0

17.7

29.8

24.2

13.3

1.3

25.2

21.3

10.2

Source: Zheng Jingping, Fast and stable economic growth in the first half of 2006. National Bureau of Statistics of China, Jul 18.

The hard landing of the economy could have an adverse impact on employment. China has experienced the development of a labor market with increasing market allocation accentuated by downsizing of SOEs (Brooks and Tao (2003)). In addition, rural employment growth declined. There is still a surplus of labor of about 150 million in the rural sector plus 10–11 million in SOEs. China faces the challenge to move this labor surplus into jobs while adjusting to its accession into the WTO. Brooks and Tao calculate that with average GDP growth of 7 percent per year and an employment elasticity of 0.5, the rate of unemployment could double to 10 percent over 3–4 years. Compensation could occur by increasing employment in the private sector and laborintensive industries. According to Dooley et al. (2005), China needs to create 10–12 million new jobs a year in urban centers. Growth of real GDP of 8 percent creates 10 million new jobs per year, 3 million of which is in export activities. Because there are 200 million potential workers outside the modern labor force in China, the system could last another 20 years. The maintenance of a required rate of growth to absorb surplus labor would be the main motivation for Asian governments to finance the United States CAD.

66 The Global Recession Risk Table 2.3 China, growth of selected industry and installed capacity year-on-year, June 2006 Industries Industrial enterprises Textile industry Chemistry Non-metal mineral products Ferrous metal smelting and processing General equipment manufacturing Transportation equipment manufacturing Communications, computer and electronics Electric power production and supply

17.7 15.4 19.8 22.1 16.3 21.8 24.1 25.7 12.2

Capacity increase Coal Crude oil Electricity Pig iron Crude steel Rolled steel Cement Autos

12.8 2.1 12.0 20.8 18.3 25.8 20.8 27.8

Source: National Bureau of Statistics of China, Jul 20, 06.

Industry and installed capacity in China continue to grow at extremely high rates (Table 2.3). There were double-digit growth rates in industry as a whole and in most branches of industrial activity. A similar phenomenon occurred in installed capacity.

The Chinese exchange rate There is a common misconception that the United States CAD is merely the mirror of the Chinese surplus. The undervaluation of the CNY and cheap labor would be the causes for a relative advantage of China in exporting to the United States. The actual problem is more complex and its solution requires diplomatic skills and a sound strategy. There is risk that an inadequate strategy may cause an even more difficult situation. There is some initial background material below on the causes and consequences of China’s current account surplus to place policy in perspective. It may be quite difficult to persuade China to revalue the CNY simply to reduce the United States deficit. The IMF believes that the CNY is not undervalued but that revaluation is necessary for the stability of China and to avoid a hard landing. Thus, both

China in Need of a New Paradigm 67

the view of undervaluation and the IMF emphasis on domestic reform lead to the same policy of appreciation of the CNY. As in all economic debates, there is a third view of maintaining the peg of the CNY to the dollar as well as differences in timing, magnitude of appreciation and exchange rate regime, managed float or more flexibility. It is useful to consider the growth of trade and the origin of the peg of the CNY to the dollar. In the past two decades, China has experienced an average growth rate of 8 percent per year, becoming the sixth largest economy in the world. Its share in world trade has grown from 1 percent in 1979 to around 6 percent in 2003. In 1979–2003, while world trade grew at an average yearly rate of 7 percent, China’s trade grew at 15 percent per year. Prasad and Rumbaugh (2004) believe that China could still maintain high rates of trade growth because other Asian countries maintained even higher rates during a longer period of 30 years. China’s low per capita income of $1000–2000 suggests that there are still many potential opportunities for rapid development. China had a fixed exchange rate with periodic devaluation through a large part of the 1980s (Wang (2004)). It implemented a dual exchange rate system in 1988–93, with an official exchange rate and a swap rate determined in various centers by trade transactions. The swap rate depreciated while the official rate became overvalued. In 1994, the authorities devalued the official rate and unified it with the swap rate into a single rate. Officially, the new system was a managed float. In practice, the exchange rate remained fixed to the dollar at CNY8.2770/USD. The real exchange rate, relative to the CPI, has not been fixed. In 1997–2003, the real exchange rate depreciated by 4 percent. The CNY also fluctuates in accordance with changes in the dollar relative to other currencies. Trade continues to grow rapidly. The trade surplus of China reached $10.4 billion in July, the largest in 2005, and more than five times the surplus of $2.03 billion in the same month a year earlier (Wu and Huo (2005Aug12)). Exports in July increased by 28.7 percent relative to a year earlier, reaching $65.6 billion, while imports grew by 12.7 percent, to $55.2 billion. In the first seven months, the trade surplus reached $50 billion, almost twice the surplus of $32 billion in 2004. The EU was China’s main market, followed by the United States. Consumer prices increased by 1.8 percent in July relative to a year earlier pressured by increasing fuel and food prices. In the first seven months, consumer prices increased by 2.2 percent relative to the prior year. There was structural change in China’s trade. Between 1993 and 2003, the share of machinery and transport, including electronics, in China’s exports increased from 17 to 41 percent while the share of mis-

68 The Global Recession Risk

cellaneous manufacturing, or simpler products, declined from 42 to 28 percent (Rumbaugh and Blancher (2004a)). The share of imports for processing jumped from 35 percent in the early 1990s to 50 percent in 2003. As part of WTO accession, China will open various activities to foreign participation, including telecommunications, financial services and insurance. There will eventually be full access by means of licensing procedures. An important characteristic of Chinese exports is their high content of imports. Lau (2003) argues that the Chinese trade surplus is significantly the trade surplus of other Asian countries. Exports from these Asian countries have been rerouted through China for assembly and final production. As a result, the actual value added in China of its exports to the United States is only 20 percent. Thus, a revaluation of the CNY by 10 percent would only increase the cost of Chinese exports by 2 percent. According to Lau, the Japanese yen appreciated from 360 per dollar in the early 1960s to its current levels slightly above 100 but there was no reduction of Japan’s trade surplus with the United States. Prasad, Rumbaugh and Wang (2005) quote an unpublished work by Robert Mundell, arguing that revaluation would frustrate export growth and FDI inflows, which provide the engine of growth and employment creation in China. However, Prasad, Rumbaugh and Wang argue that a moderate appreciation of the CNY would not have much of an impact on China’s external competitiveness because of the high import content of its exports. While the CNY effectively appreciated by 7 percent in 1999–2002, China’s total exports increased by 37 percent. More than one-half of China’s exports consist of finishing locally imported products. Calculations show that only 20 percent of the value of Chinese exports to the United States is added in Chinese production. The similar calculation for exports to the rest of the world is 30 percent. The appreciation of the CNY increases the effective cost of adding value in China but simultaneously lowers the value of the imported component. China also fears that the appreciation of the CNY could lower agricultural prices, creating more surplus agricultural labor, already at 150 million. However, there is no evidence of such an effect and Chinese agriculture has increased productivity, becoming less vulnerable to shocks. An important explanation of the current account surplus of China is the ineffectiveness of capital controls to prevent an inflow of capital in anticipation of revaluation of the CNY. Prasad and Wei (2005) provide perceptive insight into China’s capital flows. In 2001–04, approximately 60 percent of FDI inflows into China originated in Asian economies—Hong Kong, Japan, Korea, Taiwan and Singapore. The

China in Need of a New Paradigm 69

origin of investment in more technologically-advanced economies suggests that FDI into China results in economic modernization. The United States and the European Union account for only 15 percent of FDI inflow into China. Approximately two-thirds of FDI went to manufacturing and about 10 percent to construction. Electronics and communication equipment have the highest share of manufacturing FDI. Outflows of FDI are minor, about $3 billion in 2003. International reserves have increased sharply, from $50 billion in 1990–93 to $409 billion at the end of 2003, $1044 billion in 2006 and $1264 billion in 2007. Allowing for the use of $52 billion of reserves in the recapitalization of banks, reserves increased by $206 billion in 2004, at the average rate of $17.2 billion per month. China’s reserves amounted to 32 percent of GDP in 2003 and may be above 40 percent of GDP currently. An important contribution by Prasad and Wei is the decomposition of reserves. Non-FDI inflows and errors and omissions increased from a negative average of $53.6 billion in 1988–2000 to $18.3 billion in 2001–03, or $72 billion a year. Errors and omissions increased from $15.4 million on average to $7.1 billion. The authors conclude that “hot money” has been driving reserve inflow instead of the trade surplus and FDI. The positive interest rate differential between China and the United States and the expectation of revaluation of the CNY stimulated the capital inflow into China. These inflows could continue in the future if the interest rate differential and the expectation of revaluation persist. There is doubt if capital controls are effective. The data suggest that hot money moved out of China in the earlier period and returned recently, raising the issue as to how much capital is still overseas. Calculations by Prasad and Wei suggest that the earlier outflow has not been reversed entirely. The financial costs of reserve sterilization in China have been relatively minor. The yields on the investment of reserves, such as medium and long-term bonds of industrial countries, are higher than the PBC bills used to sterilize reserves (Prasad, Rumbaugh and Wang (2005)). However, the negative domestic real rates of interest may be causing major misallocation of resources with excess capacity and NPLs. There are doubts that capital controls can be effective over long periods, especially under pressure of domestic distortions. Prasad, Rumbaugh and Wang list some of the avenues for circumventing capital controls: • under- and over-invoicing of import and export contracts • transfer price schemes by transnational companies

70 The Global Recession Risk

• leads and lags in the settlement of commercial contracts • manipulation of the terms of short-term trade credit • remittances of savings by workers at home and abroad In fact, the stronger the expectations of a movement in the exchange rate, the higher the incentive to circumvent capital controls. Two historical episodes illustrate the ineffectiveness of capital control in the presence of imbalances: Japan in the 1970s and Latin America during the debt crisis of the 1980s. There is an important social cost of the exchange rate policy of China. The PBC sterilizes most of the accumulation of reserves by issuing low-yielding government bonds. The state ownership or control of the banks permits this mechanism. The yield on these bonds is approximately the cost of these reserves. As a result, savers contribute a significant part of the cost of the sterilization policy in the form of low rate of remuneration of savings. Prasad observes that the current account surplus of China is 5 percent of GDP. The identity of the national accounts states that the current account equals savings less investment. Because savings in China are about one-half of GDP, the current account surplus suggests an investment rate in China of 40–50 percent of GDP, with a major share by enterprises. Undoubtedly, a country’s development requires investment. However, investment has concentrated in China in a few activities: aluminum, autos, cement, real estate and steel. This investment has been financed mostly by bank loans in the cheap credit environment of reserve sterilization. China could be building excess capacity in these activities for the internal market. In the process, it may have created another round of NPLs in banks and thus a future deficit in another wave of bank bailouts. These investment activities have driven economic growth in China, raising doubts as to a future adverse correction. The flexibility of the CNY would prevent the sterilization of reserves, cooling the source of credit. Prasad argues that China requires financial reform. In the short-term, the effort must concentrate on banks. There are evident hurdles. Chinese banks are relatively very large, with hundreds of thousands of employees and tens of thousands of branch offices. Likely, the credit decision is quite weak. Flexibility of the exchange rate is required to eliminate the distortion that sterilization causes in financial intermediation and ultimately in efficient resource allocation. Dooley et al. (2005) state that China’s reserves increased by $207 billion in 2004 and by $162 billion in 2003. The PBC experienced

China in Need of a New Paradigm 71

an increase of net foreign assets of CNY1.58 trillion, or $191 billion. Net domestic assets declined by CNY980 billion, or $118 billion. Thus, the authorities sterilized 62 percent of the reserve inflow ($118/$191). The sterilization effort has been magnified by reserves over $1 trillion after 2006. There are many views on the existence of undervaluation and its magnitude. Bergsten (2005) warns that an economic clash between China and the United States is almost inevitable. He proposes a larger revaluation of the CNY and a joint US-China initiative to revive the Doha Round. According to his estimates, China’s trade surplus could triple in 2005 and the current account could double, reaching $150 billion or around 7.5 percent of GDP. He also observes that the US CAD is close to $800 billion, or around 7 percent of GDP. Bergsten argues that these imbalances are not sustainable and that inevitably the dollar will collapse, forcing adjustment in surplus and deficit countries. The conflict between China and the United States will arise from political restraints: The coming clash of the titans will derive primarily, however, from domestic political unsustainability. Currency over-valuation and the external deficits they spawn are by far the most reliable predictors of trade protectionism in the US (and Europe). Bilateral trade imbalances, while irrelevant in economic terms, are politically potent and the US deficit with China now exceeds annual rates of $200bn. US imports from China are six times as large as US exports to China so those exports must increase six times as fast as imports just to keep the imbalance from increasing. Bergsten proposes that the conflict could be avoided if China increased its revaluation to 10–15 percent, which would only compensate for the decline of the CNY in the past three years, but preferably 20–25 percent, which would reduce the US CAD by $100 billion. He argues that China should worsen its budget position to avoid adverse effects on demand. Otherwise, the Senate could pass the Schumer Amendment, which would impose a 27.5 percent tariff on all imports from China. The Senate bill could mesh with legislation by the House that facilitates trade barriers against Chinese imports. Bergsten contends that the President may not be able to veto the final bill because of growing resentment of China. He also predicts that Treasury may classify China as a “currency manipulator” in its October report to Congress, requiring a remedy or

72 The Global Recession Risk

more likely Congressional measures. The report did not classify China as a currency manipulator. Goldstein (2004) contends that the CNY is undervalued by 15–25 percent and that China has manipulated its currency in conflict with the “IMF rules of the game.” Article IV 1(iii) of the IMF provides that members should not manipulate their exchange rates to prevent adjustment of the balance of payments or to gain an unfair competitive advantage over others. He argues that both China and the rest of the world would gain by appreciation of the CNY. Goldstein advises that China should not float the CNY and liberalize capital markets. Instead, there should be a two-stage currency reform. The ideal regime would be a basket peg, a 15–25 percent revaluation and a band with wider limits of 5–7 percent above and below the new peg. In the second stage, after strengthening the banking system, China should adopt a managed float, with more substantial liberalization of capital outflows. Frankel (2005b) estimates undervaluation of 35 percent. He finds that the economy is overheated and appreciation would limit inflationary pressure. There are also doubts if the peg of the CNY is effective. Rajan and Subramanian (2004) argue that the adjustment of international economic imbalances requires an increase in savings in the United States and demand in the rest of the world. They contend that greater exchange rate flexibility of the CNY would contribute to this adjustment. Growth of trade in a country causes adoption of new technologies, increasing productivity with resulting higher wages in the export sector and also in the whole economy. The sector engaged in production of non-traded goods does not enjoy productivity increases similar to those in the export sector and to break even must have higher prices. The 200 million unemployed or underemployed may limit increases of wages. However, some types of more skilled labor in short supply may obtain higher wages. Real appreciation of the exchange rate occurs through inflation with a fixed nominal exchange rate. The authorities control the nominal exchange rate but not the real exchange rate. Microeconomic measures, such as price controls, may help to restrain inflation. Macroeconomic measures, such as reserve sterilization, repressed interest rates and capital controls, may repress the inflation originating in current account surpluses. Rajan and Subramanian question the viability of the system: But the New Bretton Woods system contains the seeds of its own demise. The cost of microeconomic distortions—an unviable domes-

China in Need of a New Paradigm 73

tic sector exerting a drag on long-run growth—will mount and be reflected in the fiscal burden of accumulating non-performing loans in public-sector banks. On the macroeconomic side, barring a sustained decline in growth, China will continue to attract capital. The capital account will become more open as expanding trade makes it easier to evade capital controls. As sterilization reaches its limits, capital inflows will push up credit and prices. Rajan and Subramanian argue that exchange rate flexibility would diminish international economic imbalances. However, the advice of the IMF is of importance to sustainable development and progress in Asia. Eichengreen (2004a) believes in the argument of the theory of optimum currency areas that a large country with distinctive business cycle should have a flexible exchange rate. The United States, Japan and the Euro zone have a flexible exchange rate. The question becomes not if China should adopt a flexible exchange rate but rather when. An important argument in favor of a change in the exchange rate regime in China is the need to pursue monetary policy. The peg of the CNY prevents an independent monetary policy instead of one influenced by foreign conditions and the peg. The Chinese authorities fear adverse effects in exiting the fixed rate. Based on exit theory and experience, Eichengreen proposes that there is no ideal time to exit. Thus, China should abandon the peg sooner than later. It is convenient to abandon a regime when capital inflows are abundant and the exchange rate is perceived as strong. There may not be a convenient opportunity in the future. Eichengreen contends that China does not need one large revaluation. Policy should consist of a new exchange rate regime that is more consistent with internal needs and financial characteristics. His proposal is an open-economy inflation targeting. The authorities would manage policy to avoid deviations of growth and inflation from targets. There would be some intervention in the exchange market to limit fluctuations that could adversely affect growth and inflation. The regime would be a managed float with inflation targeting. Capital account liberalization should proceed slowly to avoid disruptions. The new exchange rate regime should precede capital account liberalization. There is dissent on the need for a change in policy by China. Stiglitz (2005) contends that the trade surplus of China is not observed accurately because of over-invoicing of exports and under-invoicing of imports in expectation of CNY revaluation. He argues that because of

74 The Global Recession Risk

the large imported component of Chinese exports, the change in regime may not affect China’s competitiveness. The effective appreciation may have been only 1 percent. Stiglitz believes that even higher revaluations may not affect China’s competitiveness because companies would cut profit margins. He argues that the United States trade deficit equals capital inflows, which equal the difference between domestic investment and savings. Thus, as the fiscal deficit increases, domestic savings decline and the trade deficit increases. The United States will only diminish its trade deficit if investment declines and/or savings increase. If the trade deficit were to disappear, China would no longer fund the United States fiscal deficit, causing an increase in medium and long-term interest rates that would eventually burst the housing bubble. The change in exchange rate regime required years of multilateral efforts. In the Article IV consultation, the PRC agreed with the IMF on the need for exchange rate flexibility (International Monetary Fund and PRC (2004Jul6)). However, the Chinese authorities expressed concern that possible appreciation of the CNY could affect domestic economic growth and employment. The authorities argued that China needs 20–25 million new jobs a year to employ new entrants in the labor force, the unemployed and migrants from rural areas. The Executive Directors of the IMF warned that rapid growth of money and credit could create economic imbalances. The IMF also advised China to control budget expenses. The diplomatic effort of the United States to change the exchange rate regime extended over two years (Balls, Dickie and Alden (2005)). It required persuading the Chinese of their own benefit in changing and of the United States Congress and the private sector of the convenience of waiting for the change. There was laborious and protracted diplomacy in a difficult process. The initial effort consisted of persuading the governor of the PBC, Mr. Zhou, that revaluation would be in China’s best interest, allowing the country to pursue independent monetary policy. It was also in China’s self-interest to promote broader adjustment in Asia within a multilateral effort to rebalance trade flows. In addition, the United States combined its efforts with the G7, the IMF and the World Bank, emphasizing the benefit of revaluation for the world economy. It was equally difficult to persuade Congress to wait for a change in China’s policy. Inside China, the revaluation had to be approved by the premier, Wen Jiabao, whose personal characteristic has been caution. There could be potential adverse repercussions in the domestic economy if

China in Need of a New Paradigm 75

export growth declined because of the belief in China that growth must be very high to create some 20 million new jobs per year. The task of the governor of the PBC in his country was as arduous of that of the United States officials. Lindsey (2005) analyzes the opposing groups on CNY flexibility in China’s power structure. Officials in charge of financial and monetary affairs were in closer contact with the United States and foreign countries, visualizing the need for reform. However, those groups in charge of reducing rural-urban disparities and absorbing the unemployed in agriculture were fearful that flexibility could worsen their affairs. The appreciation of the CNY would cause a collapse of agricultural prices, worsening social conditions in agriculture. Lindsey argues that the two groups reached a compromise, a change in the exchange rate regime with an initial small appreciation of the CNY. McCormack (2005b) observed significant tension over growth policies between the technicians at the PBC and the ministry of finance and regional political leaders. There is impatience in the central and western regions of China with the postponement and even cancellation of investment to cool down the economy. Thus, the central authorities have been frustrated and delayed in implementing adjustment measures. The problem is exacerbated by the lack of monetary policy instruments. China has 150,000 SOEs to which commercial banks have been lending for years. The tensions have resulted in protests, which further augment the caution of authorities and the aversion to change. Police data show that “mass group incidents,” or protests, rose from 8700 in 1993 to 58,000 in 2003 (Tanner (2005)). Moreover, protests occur in all regions of China. A large number of these protests occur in “rust belt” provinces bordering North Korea, where there have been layoffs. The organization, frequency and size of the protests have been increasing. Part of the motivation of the protests is the nature of political and legal institutions. There is no vehicle to accommodate citizen grievances and widespread corruption. The older methods of repressing protests rapidly eroded. Police are merely isolating the protest areas. They also make arrangements with the rank and file to isolate leaders. Finally, Chinese authorities announced that they will no longer peg the currency to the dollar but rather to a narrow band against a basket of currencies (Areddy (2005c)). The motive for the change was made “with a view to establish and improve the socialist market economic system.” There were concerns in markets that the revaluation could affect interest rates. The ten-year Treasury note rose in yield from

76 The Global Recession Risk

4.17 to 4.28 percent. There was also fear that the revaluation could increase the price of Chinese imports, causing inflation and an increase in rates. Foreign bankers in China believe that the CNY will remain at around 8.11 per dollar in the 3–6 months after revaluation (Green (2005)). There probably will be some more flexibility. The combined exchange and interest rate flexibility could be a step forward for China in allowing markets to determine key prices of credit, trade and capital flows. It could be a first step toward liberalization of markets and the capital account. Sterilization was becoming quite difficult, with the PBC increasing its issuance of bills by more than 12 percent of GDP in June 2005. Price controls to restrain inflation were damaging to resource allocation, distorting the variables used in economic decisions. Fundamentals were propitious for the move, in particular, because of GDP growth of 9.5 percent in the second quarter. According to estimates by banks, the CNY is 10 percent more competitive on a trade-weighted basis than three years ago. Economists express disappointment with the limited revaluation. Goldstein and Lardy (2005) contend that China’s revaluation by 2 percent was unimportant. They argue that adjustment of the trade surplus would require a revaluation of 20–25 percent. They calculate that the 2 percent revaluation would only depreciate the tradeweighted value of the dollar by 1 percent. The United States current account would improve by around $10 billion, which is insignificant relative to the CAD of $660 billion in 2004. They welcome the peg to a basket but argue that there are no other signs of change. According to Taylor (2005), China’s new exchange rate regime will allow the PBC to pursue monetary policy while continuing modernization of its financial system. In particular, the monetary authorities will be able to implement interest rate policy to attain desired price stability. China could reduce the risks of overheating and hard landings that would have adverse effects at home and abroad. Exchange rate flexibility would contribute to reducing external imbalances by changing relative prices of exports and imports. Other central banks in Asia may follow the Chinese example. He identifies four aspects of the strategy of the United States over two years: • Benefits of flexibility. The US discussed with China the benefits for its economy and the global economy of a more flexible exchange rate policy

China in Need of a New Paradigm 77

• Market reforms. There was cooperation with China on prior measures for a successful change, such as the development of spot and futures markets • Multilateral G7 endorsement. The United States persuaded other G7 members for a multilateral effort, including a meeting of central bankers and finance ministers of the G7 with the governor of the PBC • Enhanced communication and cooperation. The United States discussed the strategy with Congress and the private sector to avoid isolationist legislation United States authorities welcomed the initial move in the CNY and warned that China required a learning process to move to a new regime (Ip (2005)). The PBC continued its reform of foreign exchange by expanding foreign-exchange forwards and authorizing currency swaps (Dow Jones Newswires (2005a), People’s Bank of China (2006)). The PBC only authorizes a few state banks to operate in forwards and under close scrutiny. Commercial banks, policy banks and foreign banks and their branches in the mainland can apply for approval to operate in forwards. The new regulations authorize transactions in these exchange derivatives and also in items other than trade transactions, that is, including selected items in capital and financial account business. These items include: “foreign exchange revenue of domestic institutions listed abroad, the paid-up capital of foreign-invested enterprises, the revenue and expenditure of foreign direct investments, and the repayment of foreign loans and non-yuan-denominated loans under banks’ proprietary business.” The banks can freely quote forward prices to their clients. The PBC warned that transactions could not include exchange of interest rates or interest-rate swaps. The governor of the PBC, Zhou Xiaochuan, revealed key currencies included in the basket of the CNY peg: United States dollar, euro, yen and South Korean won (Areddy (2005b)). In addition, currencies of countries with more than $10 billion in yearly trade with China could be included. Potential currencies are those of Singapore, UK, Malaysia, Russia, Australia, Thailand and Canada. This partial information reveals an intention to truly make the CNY more flexible. However, the authorities stated that the basket is only a reference, hinting that the process will be more arbitrary than in countries such as Israel and Singapore. There is still the test of Congress. The currency report of Treasury did not contend that China manipulates its currency. There were initial

78 The Global Recession Risk

hopes that the change to a new regime would diminish somewhat legislative action against Chinese trade (Alden and Sevastopulo (2005)). However, the proponents of the legislation stated that more change would be needed.

The need of a new paradigm The monetary authority of China is giving priority to risks originating in accelerated growth of fixed-asset investment, structural imbalances in trade, abundant liquidity and global imbalances (People’s Bank of China (2006)). The intention of policy is to mitigate these risks. China experienced growth of 18.4 percent year-on-year of deposits at financial institution and of 14 percent in loans during the first quarter of 2006. The PBC raised the benchmark interest rate of loans of financial institutions with one-year maturity by 0.27 percentage points, from 5.58 to 5.85 percent. On July 5, the PBC raised the reserve requirement of deposits at financial institutions by 0.5 percentage points. The intention of policy was to prevent adverse effects resulting from rapid growth of fixed investment, money and trade surpluses. The Financial Times (2006Apr28) observed that the increase in interest rates in China is insufficient. China needs to reduce its intervention in the currency markets and to develop a more advanced monetary system for monetary policy to be effective. While there is restrained consumer price inflation, China is experiencing producer price inflation. The National Bureau of Statistics revealed that industrial producer prices increased by 3.5 percent in June 2006 relative to the same period in 2005. The prices of processed mined products rose by 16.7 percent and raw materials by 8.5 percent. The total deposits in banks in China are around 160 percent of GDP in contrast with only 25 percent for government debt (Goodfriend and Prasad (2006)). The stock and corporate bond markets are minute. China followed a policy of directed lending by banks to state companies during the 1980s and 1990s. The policy ended in 1998. The loans transferred to asset management companies had a low recovery rate of 20 percent, showing their unsoundness. Policies of ceilings on loan growth and reduction of the rate of NPLs may have stimulated banks to roll over bad loans to avoid classifying them as NPLs. The rigidity of the exchange rate has prevented the effectiveness of interest rate policy in China (Goodfriend and Prasad (2006)). The international reserves of China reached $824 billion in 2005, a year in which the trade surplus contributed to reserve accumulation. The

China in Need of a New Paradigm 79

monthly increase in reserves during 2005 was around $17 billion. In 2001–04, reserve increase was substantially the consequence of speculative capital inflow into China in anticipation of the revaluation of the currency. Government bonds constituted the main instrument of sterilization but were replaced in that role by bills of the PBC. The rates on these bills have remained low. Corporate savings have been quite high ending up in deposits in the banking system, contributing to the abundance of bank liquidity. There is an incentive for banks to hold central bank bills because they do not have a capital requirement in contrast with 100 percent for corporate lending. The rigidity of the exchange rate system also affects bank reform (Goodfriend and Prasad (2006)). The authorities control credit growth with administrative pressure instead of interest rate policy. The banks continue to lend by guidelines of the PBC instead of by calculation of risk and return. The process of financing inefficient state companies continues without check. An important cost could be in the form of low remuneration of savings. China has grown at extremely high rates during nearly three decades. Table 2.4 shows the growth rates of GDP, population and prices since 1979. There has been major structural change. The share of the rural population in the total declined from 80 to 58 percent, significantly increasing output per head. The model adopted by China has been a socialist market economy. The political system has remained largely closed and there are no expectations of change. The leadership of China is increasingly concerned with protest and the welfare of the agricultural population. In recent years, China has joined the WTO, opened its financial system to foreign ownership, absorbed huge amounts of foreign investment and increased its share of trade in world markets. The failure of monetary policy illustrates the need to change the paradigm of China’s modernization and integration with the world economy. China’s policy approach during rapid growth in the past decade has followed general principles but has lacked a detailed approach (Prasad and Rajan (2006)). An important characteristic has been the coexistence of a planned track and a market track for certain areas of the economy. Prasad and Rajan advise that there is need for a change in this paradigm. The share of the market economy in total activity is between one-half and two-thirds. In addition, China has integrated into world trade and financial markets. The directed economic activities of the planned track conflict with the efficiency needs of the market track. China may have to choose between maintaining control and further liberalizing the economy.

80 The Global Recession Risk Table 2.4

Growth of China since 1979

Year

GDP

Per Head

1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

7.6 7.8 5.3 9 10.9 15.2 13.5 8.9 11.5 11.3 4.1 3.8 9.2 14.2 13.4 12.7 10.5 9.6 8.8 7.8 7.1 7.9 7.5 8.3 9.5 9.5

6.1 6.5 3.9 7.4 9.3 13.7 11.9 7.2 9.8 9.5 2.5 2.3 7.7 12.8 12.2 11.4 9.3 8.4 7.8 6.8 6.2 7.2 6.7 7.6 8.8 8.8

POPUL Millions

Percent Rural

987

80.6

1058

76.2

1127 1143 1158 1171 1185 1198 1211 1223 1236 1247 1258 1267 1276 1284 1292 1299

73.8 73.6 73.1 72.5 72 71.5 70.9 69.5 68.1 66.6 65.2 63.8 62.3 60.9 59.5 58.2

Source: National Bureau of Statistics of China.

CPI

CPI Urban

CPI Rural

–12.6 0.3 2.9 7.8 8.2 –5.6 –7.2 –5 –3.5 –0.6 1.8 0.3 –1.5 2 2.7

–12.9 3.7 3.3 6.9 7.7 –6.6 –6.8 –5.2 –3.6 –0.7 2.1 0 –1.7 1.9 2.4

–12.4 –2.1 2.3 8.6 8.5 –4.8 –8.2 –5 –3.4 –0.5 1.4 0.9 –1.1 2 3.1

3 Japan after Deflation

Summary The Prime Minister of Japan, Junichiro Koizumi, obtained a landslide victory in the election of September 11, 2005.9 The ruling Liberal Democratic Party (LDP) has now a two-thirds majority in the lower house. Thus, it can pass the bills in the lower house even if they are rejected by the upper chamber. The voter turnover was 67.5 percent, the highest since 1990. An increase in confidence by Japanese consumers could be important in finally recovering the economy from the “lost decade” caused by the deflation that followed sharp declines of asset prices. On September 12, the revision of first-quarter GDP showed growth of 3.3 percent, three times faster than originally reported. Koizumi called the election because of the defeat of his bill to privatize Japan Post, the largest financial institution in the world, with $2–3 trillion in deposits and 23,000 branch offices. He has advocated shrinking government with a larger role of the private sector. To be sure, Japan Post will only be privatized in 2017. However, it is an important change in direction similar to the change in the exchange rate regime in China. Japan requires important microeconomic reforms to increase productivity. Potential GDP growth in Japan is one percentage point lower than in the major industrial countries. Japan suffers from inefficiency in agriculture with producer support estimates of 58 percent, well above 20 percent in the United States and 35 percent in the European Union. Japanese banks finally stabilized their NPLs but still suffer from low profitability. Japan has significant home bias in investment, or preference for domestic securities, at a high cost of diversification. 81

82 The Global Recession Risk

Labor markets are inflexible, requiring higher participation of women in the labor force. The ageing population of Japan has reduced the savings rate and creates major future social security expenses. Corporate governance is deficient and not conducive to optimization of shareholder value. The net public debt of Japan is about 80 percent of GDP and the deficit 7 percent. The country requires a major fiscal effort to stabilize and then reduce the debt. These challenges of structural reform would not be possible in an environment of political confrontation. Countries with a single party that remains in power for generations find significant hurdles in implementing change. The LDP has held power in Japan for over 50 years. Change is possible but difficult. The ruling party in Mexico during 70 years, Partido Revolucionario Institucional (PRI), took deep measures to reform the economy and even turned over power to another party. However, the process was not simple or without confrontation. Japan is extremely important in geopolitical influence in Asia. It is the only balance on the continuing rise and influence of China. A sound economic recovery of Japan with stable political development is strategically important to world stability. Japan is the second largest economy in the world and its continuing economic weakness adversely affects global trade and growth. Recovery of Japan would make the world less dependent on United States growth because of the continuing weakness in Europe. Various sections below consider the economic distress of the “lost decade,” the analysis of deflation, the conduct of monetary policy, the intervention in the foreign exchange rate and the required structural reforms. The conclusion draws on the analysis of the IMF on the microeconomic reform and macroeconomic management of Japan.

The lost decade Japan has experienced a weak economy during a prolonged period known as the lost decade. The collapse of asset prices characterized Japan’s deflation (Baba et al. (2005)). The Tokyo Stock Price Index (TOPIX) stood at 773.1 in April 2003, the same level as in 1984. The TOPIX increased by about 400 percent in 1980–89 and declined by 70 percent from the peak to the low in 2003. The price index of urban commercial land increased by 500 percent in 1980–92; it declined subsequently by 85 percent. During Japan’s “lost decade,” 1991–2002, GDP grew at 1.0 percent on average, the CPI by 0.1 percent and the implicit deflator by –0.8 percent. In contrast, the average growth rate

Japan after Deflation 83

was 4 percent per year on average from the mid-1970s to 1992 (Ito (2004a)). The Bank of Japan (BOJ) began an easy policy in the summer of 1991, reducing the call rate by 800 basis points to 0.5 percent in the summer of 1995. The call rate was lowered to zero after 1999 except for August 2000–February 2001. Baba et al. (2005) contend that the adjustment of the excessive accumulation of capital and debt in the late 1980s and early 1990s caused the stagnation of Japan. The decline in asset prices drove the need for adjustment to financial accelerator problems, including NPLs. There were impressive yearly double-digit increases in asset prices, such as of land in large cities and the stock market index, in the second half of the 1980s (Table 3.1). Both short- and long-term interest rates were at relatively low levels for those years. Japan had been able to control its inflation problems of the 1970s. The unsecured overnight call rate of interbank deposits is the policy rate of the central bank of Japan. Both the call rate and the yield of the ten-year Japanese government bond (JGB) were low relative to those in other major industrial countries. The long-term loan rate was also relatively low, especially when compared with the double-digit increases in asset prices. The money supply, as measured by M2, was growing at more than 10 percent per year on average. It appeared that a new era had arrived in Japan. There was a major economic disaster after 1991. Land prices in large cities declined very sharply in the first half of the 1990s and have declined in every year since 1991. Investors acquire land with bank loans so that the collapse of asset prices affected both borrowers and creditors. Beginning in 1995, the BOJ lowered the call rate toward zero where it has been for the past years. The yields on the ten-year JGB are the lowest in major industrial countries. The loan rate collapsed in the same way as bond yields. There is weak demand for loans by corporations and little interest by banks in extending loans. Although monetary policy has been quite liberal, the money stock has grown at very low rates.

Fear of deflation in Japan, China, Europe and the Federal Reserve Board Economic conditions in industrial countries caused concern that the Japanese deflation could spread to other countries. Beginning in 2001, the Fed reduced fed funds rates 13 times, for 550 basis points. In the same period, the European Central Bank (ECB) reduced the repurchase

84 The Global Recession Risk Table 3.1

Japan, asset prices, interest rates and M2 % change or % per year

Year

Urban Land

TOPIX

Call Rate

10y JGB

M2

LT Loan

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

14.3 21.3 27.9 24.4 30.1 3.00 –15.5 –17.9 –11.5 –13.4 –11.2 –7.5 –5.2 –7.3 –8.5 –8.3 –8.2 –8.4 –7.4 –3.8 3.8

9.06 48.3 10.9 36.6 22.2 –39.8 –0.1 –23.7 10.0 8.3 1.1 –6.8 –20.0 –7.6 58.5 –25.5 –19.5 –18.3 23.7 10.2 43.5

5.97 4.56 4.12 4.37 6.65 8.34 5.56 3.90 2.44 2.28 0.46 0.44 0.47 0.32 0.05 0.20 0.002 0.002 0.001 0.002 0.004

8.4 5.32 4.99 5.01 5.52 6.81 5.55 4.77 3.61 4.73 3.36 2.88 2.33 2.51 2.05 1.86 1.56 1.26 1.61 1.56 1.65

7.2 8.7 10.4 11.2 9.9 11.7 3.6 0.6 1.1 2.1 3.0 3.3 3.1 4.0 3.6 2.1 2.8 3.3 1.7 1.9 1.9

6.2 5.7 5.7 6.5 8.1 6.9 5.5 3.5 4.9 2.6 2.5 2.3 2.2 2.2 2.1 1.8 1.6 1.7 1.5 1.8

Source: Bank of Japan, http://www.boj.or.jp/en/stat/sk/ske.htm

rate 7 times, for 275 basis points. While American GDP grew by 2.9 percent in 2002 and 3.0 percent in 2003, euro zone GDP increased only 0.9 percent in 2002 and 0.5 percent in 2003. It appears that such discrepancy in growth will prevail in the future.10 The euro began trading at $1.17 in 1999, devaluing to less than $0.90 and revaluing to $1.17–$1.18. Weighted by foreign trade, the dollar devalued 18.2 percent in 2002 and 8.3 percent in the first half of 2003.11 In mid-2004, the euro traded around $1.18 relative to the dollar. Fear of deflation occurred in an environment of significant declines of equity markets, increases in idle capacity and frustration with the pace of global recovery. After World War II, economic policy concentrated on inflation control (Reinhart (2004)). However, concern with deflation developed recently after the crisis in Japan of the three Ds: Debt, Deflation and Disaster. The Fund defines deflation as a sustained decline in prices, measured by the consumer price index or the deflator of the national accounts.12 Deflation is a generalized fall of prices, or negative inflation, while

Japan after Deflation 85

disinflation is a reduction in the rate of inflation, which is still positive. The United States shows decline of the rate of inflation since the beginning of the 1980s while the only true recent deflation occurred during the Great Depression in the early 1930s. In the 1990s, the rate of inflation of the United States was 2.1 percent on average in contrast with 7.0 percent in the 1970s and 4.3 percent in the 1980s.13 The decline in prices of assets characterized past deflation, such as the collapse of the stock market in 1929, coinciding with failure of banks, decline of demand and prices. Deflation increases the real value of existing debts while reducing the real value of collateral. During the years 1929–33, the implicit deflator of the American national accounts showed deflation of 22.5 percent while real GDP fell 33 percent and real wages 45 percent. More than 5000 banks closed because of financial stress.14 There are numerous deficiencies in consumer price indexes, which do not permit substitution of goods over time, do not allow for commercial discounts and do not make adjustments for improvements in product quality. There is a common belief that indexes overestimate inflation by 1 percent. Thus, inflation of 1 percent could mean price stability. The former Chairman of the Fed, Alan Greenspan, emphasizes the importance of prices in allocation of resources in a market economy.15 The measurement of price indexes is essential to the process of formulation and implementation of monetary policy. Errors of measurement of tens of centesimal points may not be significant in an inflation of two digits, but can be very important when inflation is close to zero. Inflation of 1 percent per year with measurement error of 0.75–1 percent can imply that the economy is close to deflation. Deflation affects resource allocation in ways similar to inflation, distorting long-term planning, camouflaging true changes of relative prices and creating difficulties for processes that use nominal values such as taxes. While in inflation there is a flight from money into goods, in deflation there is a flight from goods into money. As nominal interest rates approach zero, real interest rates become positive, causing unemployment in labor markets with rigidity of nominal wages. It is not possible to adjust by deflation contracts with fixed nominal value, such as interest rates, debts and wages. While family and corporate income decline because of deflation, debts contracted earlier in fixed nominal values increase in real terms. Japan has excessive corporate debts and large volume of loans in default at banks, both increasing in real terms because of deflation.

86 The Global Recession Risk

The BOJ attributes deflation to three factors: the limit of nominal interest rate of zero that reduces effectiveness of monetary policy, the problem of NPLs in banks and the weakness of sentiment on the economy.16 Financial institutions face a reduction of capital because of the decline in market value of their positions in corporate equities and growth of NPLs. Banks are not willing to take risks because of fear of unexpected losses. Deflation originating mainly in demand factors can affect the effectiveness of economic policy. Because the nominal interest rate has a floor of zero, demand for money is perfectly elastic at low levels of nominal interests rates.17 The economy reaches equilibrium by declines of general prices and aggregate output after a downward shock of aggregate demand. A positive real rate of interest aggravates conditions. Increases in the money supply do not have an impact on output, making monetary policy ineffective. Expectations of price decline may accentuate output reduction. According to Krugman, expectations of deflation can cause downward displacement of aggregate demand.18 Actual output would decline below potential, generating further deflation. The deflationary spiral would continue with new expectations of continuing deflation, actual output below potential and renewed deflation. Transmission of deflation could be stronger in a regime of fixed exchange rates such as the Gold Standard.19 However, in a system of flexible exchange rates, deflation does not transmit easily from country to country. In fact, the Great Depression of the 1930s affected many countries with less impact than in the United States.20 In the United States, consumer prices fell 24 percent from August 1929 to March 1993. Simultaneously, real GDP declined 30.5 percent. It is difficult to identify theoretically and measure empirically the costs of deflation. However, there appears to be consensus that costs of deflation are higher when it originates in decline of demand. Deflation originating in expansion of supply, such as technological progress, can last less and have neutral consequences. During decline of demand, deflation erodes the value of collateral of debts, creating the possibility of bankruptcies. Debtors probably would not have sufficiently high income to service debt contracted before deflation. Thus, they would have an incentive to surrender collateral, now lower in market value relative to the principal of debt. The lower limit of zero of nominal interest rates prevents compensatory monetary policy. Downward inflexibility of wages can accentuate the effects of deflation. Real salaries would increase, reducing corporate profits and

Japan after Deflation 87

generating unemployment, with risks of a deflationary cycle. Historical analysis by the IMF suggests that deflation and its expectation can generalize rapidly, imposing high costs. Thus, economic policy should act preventively, effectively and rapidly. Control of deflation after it begins can be quite difficult, as shown by Japan, because, in large measure, of the limited effectiveness of monetary policy with nominal interest rates near zero. The Bank for International Settlements (BIS) estimated the frequency of effective deflation in the past five decades as the percentage of quarters with inflation of less than 1 percent for various types of price indexes.21 For basic inflation, the frequency was 3.5 percent in 1960–69, 1.6 percent in 1970–79 and 3.4 percent in 1980–89. However, the frequency increased to 14.7 percent in 1990–99, 31.3 percent in 2000–01 and 17.9 percent in 2002. The objective of a central bank consists in promoting welfare with price stability. In practice, most central banks focus on price stability with a low, but positive inflation rate. In an economy with flexible labor and product markets, slight deflation may not constitute a worse problem than low inflation. DeLong argues that macroeconomic losses resulting from deflation exceed those of the same magnitude of inflation.22 The high real rate of interest of deflation depresses investment, reduces demand and increases unemployment. By transferring wealth from debtors to creditors, deflation undermines financial intermediation, causing downward pressure on investment, demand and employment. Deflation would be more damaging if it followed accumulation of significant volumes of debt with decline of asset prices. There could be a deflationary movement of difficult control in such a case. There would be several rounds of deflation of debts, reductions in collateral in debt contracts and erosion of capital ratios. Bankruptcies of financial institutions could widen deflationary expectations. Product and employment would fall with financial markets losing their function of intermediation. Forecasts for 2002 of prices and output for countries with deflation— China, Hong Kong, Japan and Taiwan—erred significantly. The forecast of inflation of 2.5 percent for Hong Kong erred in direction with an actual deflation of 3 percent. In all countries, forecasts predicted inflation, with the exception of zero percent for Japan, with actual deflation of 0.9 percent. Forecast errors ranged from –0.9 percent to 3.2 percentage points. Forecast errors of output ranged from –0.1 percent to 4.3 percentage points.

88 The Global Recession Risk

There can be asymmetry in inflation control relative to deflation. That is, the central bank may reduce interest rates more rapidly during deflation control than during inflation control. The Fed apparently followed such a guideline during rapid reduction of interest rates in 2001, maintenance of low rates in 2002 and further reduction in rates in 2003. The IMF constructed an index of vulnerability to deflation using general prices, the gap of actual to potential output, indicators of asset markets and monetary-credit indicators. The index suggests an increase in vulnerability to deflation of some countries, but little risk for those that did not experience it. Japan shows the highest vulnerability followed by Hong Kong, Taiwan and Germany. China does not show vulnerability because of the supply nature of deflation. In the Americas, the United States, Brazil and Mexico show low vulnerability. According to the Fund, the channels of propagation of deflation are: • Exchange rate: floating rates smooth transmission while fixed rates facilitate propagation • Asset Prices: deflation distorts calculation of relative returns, frustrating risk taking • Expectations: after initiation of deflation, real wages and interest rates increase • Credit: reduction of collateral in bank loans causes defaults and credit restrictions Germany posed an important risk of deflation because of its importance in Europe. According to the IMF, the German economy showed price stability with demand constraint of growth. Economic growth, production, income and labor markets weakened significantly in 2001 and 2003. There was deeper decline of asset prices, such as equities and real estate, than in other countries. Banks and insurance companies experienced the worst conditions since World War II. There are no expectations of recovery in investment. In addition, in accordance with the Maastricht Treaty, Germany had to reduce the public deficit in 2003 by 0.75 percent of GDP, contributing to any deflationary pressure. Japan continues to experience deflation of consumer prices. There are adverse characteristics in the Japanese economy: large gap of actual versus potential output, high unemployment and record business bankruptcy. The consensus forecast attributed a 70 percent probability to deflation of 0.8 percent in 2003.

Japan after Deflation 89

Technical research on deflation by the Federal Reserve Board was a response to the lowering of the fed funds rate to 1.75 percent. Subsequently, the rate collapsed to 1 percent. There was concern that monetary policy would lose its effectiveness because of the zero lower bound of nominal interest rates. Monetary policy with zero nominal interest rates relates to the liquidity preference of Keynes. The Fed’s research concentrated on Japan, the most important, prolonged and recent experience of deflation.23 Forecasts of all types—by Japanese monetary authorities, the Federal Reserve Board of the United States, economists’ consensus and prices of financial variables—did not predict deflation in Japan. Therefore, after 1995, Japan experienced deflation without any warning by economists in the private or public sectors. Because of concern with inflation until the case of Japan, forecast of deflation, a much less frequent occurrence, defies economists technically. Forecasts of turning points of variables are deficient and rarely anticipate change in direction. In the first half of the 1990s, Japanese authorities eased monetary policy to revert the decline of economic activity. However, policy was insufficient to prevent deflation when nominal interest rates approached zero because authorities feared repetition of the puncturing of the stock market bubble. The Fed’s research concluded that in such a situation monetary policy must be more aggressive to prevent the risk of deflation. Simulations by the Fed suggest that a decrease of 200 basis points in interest rates would have broken the process of deflation. The effectiveness of monetary policy decreased, although it is of very difficult measurement. The Japanese case shows typical deterioration of balance sheets in deflation, with declines in asset prices eroding debt collateral. Monetary policy is less effective in promoting economic recovery in such an environment. Similarly, fiscal policy could have been more aggressive in Japan. Naturally, these observations take place after the facts. The Fed did not find evidence that fiscal policy lost effectiveness during deflation. Japan began to experience relief from deflation with increase in longterm interest rates to 1 percent from a low of 0.4 percent, placement of government securities and recovery in investment.24 The government opened three fronts against deflation in monetary and exchange rate policy and in non-performing loans in banks. The Ministry of Finance of Japan purchased dollars to avoid downward pressure of the JPY/USD exchange rate. Devaluation of the yen relative to the euro of around 30 percent could benefit recovery of demand through exports. The BOJ

90 The Global Recession Risk Table 3.2

Japan, GDP, prices, unemployment and government bond

Year

Real GDP

US GDP

Deflator

Unemployment

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

2.4 2.8 –0.1 –1.3 0.6 2.8 –0.8 0.8 2.3 1.7 3.2

2.5 3.7 4.5 4.2 4.5 3.7 0.8 1.6 2.7 4.2 3.5

–0.6 –0.6 0.9 –0.5 –1.5 –1.6 –1.3 –1.8 –1.3 –1.2 –1.3

3.2 3.3 3.5 4.3 4.7 4.7 5.2 5.4 5.1 4.6 4.4

CPI 10y JGB –0.1 0.4 2.0 0.2 –0.5 –0.5 –1.0 –0.6 –0.2 –0.1 –0.1

2.9 2.7 1.9 0.9 1.8 1.7 1.3 1.0 1.4 1.4 1.4

Source: Bank of Japan, http://www.boj.or.jp/en/stat/sk/ske.htm

accelerated growth of base money, trying to lower interest rates to small and medium companies. It also provided funding for repurchase of bank loans. The government nationalized bank Resona and new policy measures may occur in bank loans. Table 3.2 shows economic indicators for Japan. The Tokyo price index fell for a 45th consecutive month in June 2003, settling at 0.4 percent below a year earlier.25 The index for Japan as a whole fell by the 44th consecutive month in May 2003, 0.4 percent lower than a year earlier. Real expenditures of wage earners fell 1.8 percent in May 2003 relative to a year earlier. Japanese GDP increased at the rate of 5.9 percent in the first quarter of 2004. This rate was lower than 6.4 percent in the final quarter of 2003 but higher than the forecast of 3.6 percent. GDP increased at 4.2 percent in the second quarter of 2004. Exports and investment of companies grew by 15 percent and family expenditures by 3.5 percent. In the fiscal year ending in March 2004, Japan’s economy grew by 3.2 percent, well above 1.1 percent a year earlier, the best performance since fiscal year 1996. The BOJ intended to continue monetary policy without changes. It forecast continuing moderate fall of consumer prices on a 12-month basis after May 2004. The BOJ believed corporate prices will continue increasing moderately, primarily because of oil price increases. There was continuing milder deflation in 2004. Conditions significantly improved in Japan after 2005. Various transitory factors of deflation in China included lower prices of commodities, reduction of tariffs by entry in the WTO and controls

Japan after Deflation 91

of administered prices because of social concerns. Long-term factors consisted of gains in productivity resulting from large capital investments, reform of state companies and use of new technology in a process of foreign capital inflow within a framework of higher market orientation. Another major source of deflation originated in idle capacity resulting from inefficient operations by state companies. The former Vice Chairman of the Fed, Roger W. Ferguson, Jr., points out that the United States experienced the most important disinflation in 40 years.26 The puncturing of the stock market bubble, that reduced wealth of American families by one-half, and geopolitical tensions after September 11, 2001, constitute important determinants of this disinflation. Ferguson does not believe in the possibility of deflation in the United States. However, failure to anticipate deflation in Japan requires concern on the issue. The BOJ reduced the nominal interest rate in overnight transactions from 8 percent in 1991 to 0.5 percent in 1995, maintaining it at that level until reducing it to zero in 1999. Inflation remained at practically zero since the beginning of 1995. In March 2001, prices began to decline by 1 percent per year. Banking fragility is an important problem in Japan. Insufficient capital, non-performing loans and lack of profitability of Japanese banks prevent recovery of growth financed by bank loans. Japanese banks play an important role in the economy and, thus, in the process of transmission of monetary policy. Fragility of banks accentuates the trap of deflation. Deflation and lack of growth reduced risk taking in an economy with high capital ratios, low remuneration of investment and major economic uncertainty. Risk aversion prevents recovery of investment and growth. The IMF contends that various pressures for price decline in China affect industrial sectors globally. China is the largest exporter to the United States, sharing in 11 percent of total imports, which is only 1 percent of American consumption. However, while the percentage of Chinese goods in consumption of industrial countries is minute, its future potential could cause deflationary effects. Nevertheless, the IMF concluded that China does not transmit deflation to the rest of the world. In mid-2002, the consumer price index of Hong Kong was 12 percent below its level four years earlier and the implicit deflator 15 percent lower.27 Monetary policy increases or decreases bank reserves to determine short-term interest rates. However, the reduction of short-term rates does not influence directly long-term rates. In deflation, reduction of

92 The Global Recession Risk

long-term rates could influence recovery of investment. The central bank can repurchase long-term securities with the objective of reducing their yields. In the United States, the Fed tried to attain this effect in 2001 by eliminating the issue of 30-year bonds. Pension funds and other long-term investments carry those bonds to match their assets and liabilities. Financial institutions engaged in arbitrage by buying mortgages and securities with high duration that caused declines in long-term rates. Mortgage rates declined continuously, causing a wave of refinancing that injected more money in consumer budgets than tax reduction. The Fed’s objective was to reduce the slope of the yield curve of treasuries to decrease capital costs to companies. Weak investment was more important than consumption as a factor of the recession of 2001. Professor Bernanke underscores balance sheet effects resulting from deflation.28 When the nominal interest rate approaches zero, the expected rate of deflation is the real interest rate. During the Great Depression, American prices declined at the rate of 10 percent per year between 1930 and 1933. Deflation caused immense cost to debtors that had to repay their obligations in dollars of much higher purchasing power, the opposite of inflation. Therefore, real rates of interest became much higher because of deflationary expectations. The cost of money is prohibitive in a period of pronounced deflation. For example, interest rates of 20 percent with expected inflation of 10 percent imply real interest rates of 9 percent (1.2/1.1). Nominal interest rates of 2 percent with expected deflation of 1 percent imply real interest rates of 3 percent (1.02/0.99). Deflation originating in significant decline of demand results in output contraction, unemployment and major financial stress. Baig (2003) provides an exercise that shows the deterioration of the conditions of a borrower during the Japanese deflation. The assumption is that a borrower entered into a ten-year loan in 1997 at 2.1 percent, which was the yield of the long-term government bond. Another assumption is that the borrower expected inflation to be 1.1 percent per year during the term of the loan. By 2003, because of deflation, the obligation of the borrower in real terms would have been 12 percent higher than anticipated and 20 percent higher at loan maturity in 2007. Even if the borrower refinanced the loan at lower rates in 2003, the debt burden would have been 7 percent higher. Baig concludes that even moderate deflation deteriorates the financial position of borrowers, increasing bankruptcies and distorting investment decisions. The borrower in the exercise would have experienced a

Japan after Deflation 93

decrease in the real value of collateral by 34 percent through 2003. The deterioration in the income of the borrower and the value of the collateral has been painful to Japanese financial institutions. The government is a debtor, experiencing real increases in its debt, while the revenue declines together with deflation. Bernanke departs from the general assumption that authorities must use monetary/fiscal policies aggressively to prevent deflation by maintaining adequate aggregate expenditures. Central banks have three measures of prevention at their disposal. First, monetary authorities must fix inflation targets above zero percent or perfect stability, typically 1–3 percent in industrial countries. Secondly, central banks must use their powers of supervision and regulation to maintain a banking system that is adequately capitalized and capable of managing risks. Finally, central banks must act aggressively and decidedly, to reduce interest rates whenever there is threat of deflation. According to Bernanke, monetary policy could still be effective during deflation. The central bank always has the means to increase base money to reduce the price of currency in relation to goods, causing, eventually, an increase of aggregate demand. Holders of financial wealth are indifferent between holding money and Treasury bills at low interest. Because of high real rates, the economy can continue in deflation or recession. However, Bernanke argues that sufficient issues of currency could always reverse deflation. If the fed funds rate reached zero, the central bank would still have instruments to reverse deflation. As in the case of Japan, the monetary authority can maintain short-term interest rates at zero percent. Longterm interest rates are average actual and expected short-term rates. The zero percent interest would force the decline of long-term rates, reactivating the economy and breaking deflation. Another possibility would be to fix limits on long-term rates by purchases of government securities by the central bank. If successful, such policy would lower long-term rates of mortgages and government bonds. Short-term loans to banks at zero nominal interest would be another alternative of central bank policy. Collateral in those loans could consist of bonds and corporate debt, commercial paper, bank loans and mortgages. Aggressive policy would reduce risk spreads of assets used as collateral and, eventually, cost of capital to banks and the nonfinancial private sector. Bernanke also refers to the example of breaking deflation in the United States during the Great Depression. Gold purchases by the

94 The Global Recession Risk

Roosevelt Administration caused the devaluation of 40 percent of the dollar in relation to gold. Consumer prices fell 10.3 percent in 1932 and 5.1 percent in 1933 but increased 3.4 percent in 1934 together with economic recovery. Thus, the central bank can use exchange rate policy to reverse deflation. Fiscal policy can work in coordination with monetary policy. Bernanke mentions the example of a broad reduction of taxes financed by issue of money to prevent an increase of interest rates. Other authors would prefer government expenditures to prevent that taxpayers save part of tax reduction. Professor Bernanke declared that the Fed must be willing to lower interest rates to zero if it were necessary and perhaps adopt an inflation target.29 Even with economic recovery, the core index of personal consumer expenditures could have fallen to 0.7 percent. Consumer prices, excluding food and energy, fell to 1.5 percent per year in June 2003 in contrast with 2.3 percent a year earlier. Bernanke believes that the Fed should not tolerate further decline of inflation, maintaining inflation above the interval of 0–1 percent. At this low inflation, the Fed requires a monetary policy of the same level of stimulus required to reverse deflation. The economy would continue to lose jobs, with idle capacity. In two years, the Fed reduced fed funds rates from 5.5 percent per year to 1 percent. In case of failure to maintain inflation above 1 percent, the Fed could use non-traditional instruments. An inflation target could be a policy alternative. Other policies could consist of the reduction of interest rates by purchases of government bonds, an announced program of supply of excess bank reserves, rediscount loans to banks at very low interest rates and options to borrow from the Fed at low rates. According to Vito Tanzi, former director of fiscal affairs of the IMF, abandoning fiscal prudence could create future disasters. 30 Tanzi recalled the warning by Rudi Dornbusch that uncontrolled increase of the fiscal deficit could take Japan to disaster. The Japanese deficit reached 7.5 percent of GDP in 2002 and the gross public debt 158 percent. The major countries of the EMU, France and Germany, surpassed their deficit limits of 3 percent, which is also possible for Italy in 2004. The United States forecast a surplus of 3 percent in 2003, but there was concern that the deficit could reach close to 4 percent in 2003 and 2004. Almost all emerging countries suffer fiscal constraints. Tanzi reminds the asymmetry of fiscal policy: reducing taxes and increasing expenditures is easier than the opposite. There is a high future burden in abandoning fiscal prudence, extended to all types of countries.

Japan after Deflation 95

Feldstein warns about the risks of active vigorous fiscal policy of deflation control when inflation falls to low levels, such as 1 percent in the United States: the undesirable rise of inflation and increases in prices of financial assets and real estate.31 It is quite difficult to specify when authorities should implement such policy. In relation to the Fed’s research, there is doubt on how to determine when economic conditions are similar to those of Japan. However, fiscal policy could be appropriate to deal with more prolonged recession, such as that of Japan. In contrast with fiscal deficits causing dangerous increase of internal debt, structural and tax policies benefiting investment could be more effective and with less risk of future problems. In testimony to the United States Senate on April 20, 2004, the Chairman of the Fed, Alan Greenspan, stated that American companies recovered slowly the ability to raise prices, dispelling the risk of deflation.32 Investors began to price increases in fed funds rates in 2004, causing increases in ten-year Treasury notes to 4.47 percent. The term fed funds rates refers to the rate contracted on fed funds or balances held as reserves at the Federal Reserve Bank. The fed funds rate is the policy rate of the US central bank. There was expectation that the Fed was more inclined to prevent inflation with increases in interest rates than to maintain fed funds rates at 1 percent, the lowest level in 46 years.

Monetary policy There is initial discussion in this section of the short-term condition of the economy of Japan, followed by a description of current monetary policy. The final part considers the active debate on the conduct of monetary policy and alternative proposals. The short-term indicators for Japan revealed continuing difficulties until improvement during 2005–6 as shown in Table 3.3. Corporate prices are subject to upward pressure by oil price increases. However, there was continuing deflation into 2005 as shown by the CPI, motivating caution by the BOJ. If the index of consumer prices overestimates actual prices by 1 percentage point, there is actual deflation. In its September 2005 report, the BOJ showed more optimism about the conditions of corporate finance in Japan (Bank of Japan (2005Sep12)). There was an improved environment for the issue of commercial paper and corporate bonds, with growth over a year earlier. Credit demand by the private sector is declining less rapidly. Base money is increasing by 1 percent relative to a year earlier and the

96 The Global Recession Risk Table 3.3 Quarter

Japan, prices, stock market, call rate and industry Corporate Prices

TOPIX

Q1 Q2 Q3 Q4

1.4 1.7 1.7 2.2

2.8 19.9 16.8

2006 Q1 Q2

2.8 3

4.7 –8.2

CPI

Call Rate

Industry

–0.2 –0.1 –0.3 –0.5

0.022 0.001 0.004 0.004

1.4 –0.1 –0.5 2.8

0.4

0.004 0.0027

0.6

Source: Bank of Japan, http://www.boj.or.jp/en/stat/sk/ske.htm

money stock by 1–2 percent. Long-term interest rates are stable. Oil prices continue to drive upward corporate prices while the BOJ forecasts flat or slightly increasing consumer prices at the end of the year. At its monetary policy meeting on September 7–8, 2005, the BOJ viewed favorably economic conditions with moderate growth in exports, industrial production, business fixed investment, household income and consumption (Bank of Japan (2005Sep12)). The BOJ observed steady housing investment and declining public investment. The expectation was that the economy of Japan would “continue to recover.” Domestic corporate goods prices were increasing because of the increase in crude oil prices. However, consumer prices were declining on a year-to-year basis in part because of declines in electricity and telephone fees. The BOJ expected consumer prices to be at zero percent at year end because the increase in rice prices would compensate for the reduction of public utility rates. The BOJ observed an improved environment for the issue of commercial paper and corporate bonds. In addition, banks were moving towards increasing lending. The year on year increase in base money was 1 percent. The BOJ continues to provide “ample liquidity.” Interest rates in Japan are extremely low. The BOJ reports the one-month rate for a JPY10 million time deposit at 0.019 percent, nearly zero, and for ten years at 0.225. The certificate of deposits (CDs) issued by the larger “city banks” paid 0.022 percent for 30 days and 0.040 for 360 days. The quarterly indicators of the economy of Japan shown in Table 3.4 provide further evidence of recovery. The Deputy Governor of the BOJ argued in a speech at the Federal Reserve Bank of Kansas City (Iwata (2005)) that Japan had emerged out of the pause in 2004, caused by lower demand for Information Technology (IT), and was growing at a

Japan after Deflation 97 Table 3.4 Japan, short-term economic indicators seasonally adjusted, quarter on quarter % change 2004 Indicator Household living expenditures Department store sales Supermarket sales New passenger car registration 10,000s Sales of household appliances Outlays for travel Housing starts (annual 10,000s) Machinery orders Construction starts Value of public works contracted Real exports Real imports Industrial production Real GDP Index of all industry activity

4Q

1Q

2005 2Q

3Q

2006 4Q

1Q

–1.8 2.7 0.4 –0.8 –0.6 0.2 1.0 –0.1 –1.1 –0.5 –1.2 –0.9 344 342 362 332

0.5 –1.5 0.4 0.2 0.2 –1.4 320 336

4.3 3.4 4.9 2.7 –0.6 3.6 0.8 –1.9 117 121 119 128 5.7 0.8 0.8 3.2 –5.3 11.4 –0.5 –8.6 –7.4 0.5 1.9 –0.5 0.5 0.7 1.5 3.3 2.1 0.4 2.1 2.0 –0.9 1.7 –0.4 –0.5 0.1 1.3 0.3 0.3 –0.2 1.4 0.3 0.2

4.3 1.9 0.9 0.6 125 127 2.8 –0.4 9.3 0.9 –4.5 –6.2 2.9 3.4 0.2 2.4 2.8 0.6 1.1 0.8 1.1 0.6

Source: Bank of Japan (2005a, 17; 2006a, 17).

rate above potential. The inventory adjustment in the liquid crystal and silicon sector was completed. Moreover, the rate of change of prices was stabilizing at zero percent. According to the Governor of the BOJ (Fukui (2005)), the decline of aggregate demand, during the two recent recessions of Japan in 1997–98 and 2001–02, caused accumulation of inventories. The adjustment of inventories resulted in a weak economy. Currently, firms perceive inventories as low or normal. However, there is some inventory adjustment pressure in the IT sector. In this environment, the monetary policy of the BOJ was as follows (Fukui (2005)): Now, in a situation where short-term interest rates are constrained by the zero bound, the Bank is providing more ample liquidity to financial institutions through its “quantitative easing policy,” and has made a commitment to continue with this policy until the yearon-year rate of change in the consumer price index (CPI, excluding fresh food, on a nationwide basis) registers zero percent or higher on a sustainable basis. By implementing drastic monetary easing, the Bank has sought to avert the risk that a vicious cycle, involving

98 The Global Recession Risk

the translation of price declines into reduced corporate profits, depressed economic activity, and hence further price declines, could impair the monetary policy goal of price stability over the medium to long term. In this situation, the problems arising from the downward rigidity of nominal wages and the zero bound on nominal interest rates are unlikely to be too serious, and the risk of a negative cyclical mechanism operating between falling prices and declining economic activity is therefore correspondingly small. In fact, the economy has been on a recovery trend in spite of the continuing decline of consumer prices year on year. This suggests that the current decline in prices is qualitatively very different from that experienced during 2001–02 when the fall in demand triggered anxiety about the economy falling into a deflationary spiral. At the meeting on monetary policy in July 2005, the BOJ continued the guideline of outstanding balances in current accounts, or excess reserves of banks, of JPY31–35 trillion, relative to required reserves of JPY6 trillion (Bank of Japan (2005Aug12)). The BOJ would provide more liquidity to maintain the target if there were an increase in demand for funds. In case of a decrease in demand for funds, the current account balances may be below the target. However, there was a statement that undersubscription of money market operations was continuing. The BOJ reported that the Tankan, or short-term corporate economic survey, showed in June a significant increase in plans of business fixed investment of large manufacturing firms, one of the strongest in recent years. There was also strength of smaller firms. The June Tankan also showed stronger corporate profits. Moreover, the environment for corporate finance became brighter. The prevailing view at the meeting was that Japan was emerging from the pause of the final quarter of 2004. Some members were concerned about the rise in oil prices. There was concern at the meeting of the risks of the Chinese economy: decrease in Japanese investment, labor unrest, bottlenecks of infrastructure in electricity and water, revaluation of the CNY and uncertainty on inventory adjustment. Economic weakness in China could affect the economy of Japan via lower exports. Table 3.5 shows the evolution of the forecasts of the members of the policy board of the BOJ. The forecast is for continuing economic growth in 2006–07 with lower risk of inflation as measured by the CPI ex fresh food, which is the BOJ measurement of inflation. The members of the meeting agreed on the maintenance of the policy of quantitative easing. Some members argued that there were

Japan after Deflation 99 Table 3.5 Bank of Japan, forecasts of the majority of policy board members % year on year change Forecast Date and Period

Real GDP

Domestic CGPI

CPI (ex fresh food)

Apr 05 Fiscal 2005 Oct 2004 Forecasts Apr 05 Fiscal 2006 Apr 06 Fiscal 2006 Apr 06 Fiscal 2007

1.2 to 1.6 [1.3] 2.2 to 2.6 [2.5] 1.3 to 1.7 [1.6] 2.1 to 3.0 [2.4] 1.8 to 2.4 [2.0]

0.8 to 1.0 [0.8] 0.2 to 0.5 [0.3] 0.2 to 0.5 [0.3] 1.4 to 1.8 [1.5] 0.8 to 1.1 [1.0]

–0.1 to 0.1 [0.1] –0.1 to 0.2 [0.1] 0.2 to 0.4 [0.3] 0.6 to 0.6 [0.6] 0.7 to 0.9 [0.8]

Brackets indicate median of the forecasts Source: Bank of Japan Outlook for Economic Activity and Prices (April 2005). Tokyo, Bank of Japan, Apr 28, 05; http://www.boj.or.jp/en/seisaku/05/seisaku_f.htm

reasons to lower the target of current account balances: diminished concern about financial stability, decrease in demand for liquidity by financial institutions and possible excess liquidity. However, the majority of members were in favor of maintaining the target on current balances because of the weak evaluation of economic activity and uncertainty on prices. A member expressed the concern that lowering the target could signal that the BOJ was moving to tightening. The representative of the Ministry of Finance (MOF) recommended that the BOJ maintain its policy firmly to ensure the sustainability of economic recovery and the definitive elimination of deflation. The representative from the Cabinet Office also recommended that the BOJ maintain its easing policy to overcome deflation. The BOJ changed the framework of monetary policy on March 9, 2006 (BOJ (2006Mar9)). The new approach consists of a review of the “thinking” on price stability and the disclosure of a rate of inflation corresponding to the viewpoint of the Policy Board. The BOJ will evaluate economic activity and inflation on the basis of two “perspectives.” The first criterion is the determination of whether the outlook of economic activity 1–2 years forward is consistent with sustainable growth with price stability. The second criterion resembles risk management. The BOJ will examine risk factors that may affect sustainable growth with price stability even if they are considered to have low probability of occurrence. The framework resembles inflation targeting. The BOJ will periodically disclose its deliberations under the two criteria in its Outlook for Economic Activity and Prices. The governor of the BOJ analyzed the end of the quantitative easing framework (Fukui (2006)). The effective change in the framework on

100 The Global Recession Risk

March 9 was the adoption of the uncollateralized call rate as the instrument of monetary policy, replacing the outstanding balance of current accounts at the BOJ. A preparatory measure for the transition to the new framework was the gradual reduction of the outstanding balance of current accounts. At some point, the new framework would allow for adjustment of interest rates to maintain adequate economic activity with price stability. Fukui stated that “the Bank is determined to conduct monetary policy appropriately in the light of developments in economic activity and prices, and contribute to sustainable economic growth with stability.” The BOJ reported its view on the economy in its monthly report for July (BOJ (2006Jul14a)). The overall conclusion was that the economy of Japan is “expanding moderately.” The dynamic sectors are exports, business fixed investment and corporate profits in a favorable business sentiment. Private consumption and household income have been increasing. However, corporate goods prices continued increasing in large part because of the worldwide increase in commodity prices. The BOJ perceived an increasing trend of the year-on-year rate of consumer prices. The BOJ also observed an “accommodative” environment for corporate finance and bank lending. The year-on-year rate of growth of the money stock settled in 1–2 percent. At the meeting on July 14, the BOJ sanctioned the change in the zero interest rate policy (BOJ (2006Jul14b)). The policy rate was increased from 0 to 0.25 percent. The central bank increased the complementary lending facility to 0.4 percent. The reason for the increase in the policy rate was the view that the year-on-year rate of change of consumer prices will continue to follow a “positive trend.” Meanwhile, the economy was continuing moderate expansion. The meeting concluded that the maintenance of a zero percent interest rate in an environment of reasonable economic activity and growing inflation could have the risk of causing fluctuations in output and prices. The outlook report of the BOJ will continue to provide the information on economic activity and prices that could influence the conduct of monetary policy. The BOJ also revealed its “thinking” on price stability. It defined price stability as an environment in which economic agents make their decisions on consumption and investment without concerns about inflation and its volatility. The BOJ adopted the year-to-year change of the consumer price index as the basic indicator of inflation. A departing point of the framework is that inflation in Japan has been lower than in most major economies. The first target of price stability was consumer price inflation within the range of 0–2 percent. There are many of the

Japan after Deflation 101

basic ingredients of inflation targeting in this framework: a target range of inflation, periodic disclosure of the policy intention of the monetary authority and dissemination of information on economic activity and prices. The BOJ joined the FRB and the ECB in raising interest rates. The economy is growing at 3 percent with a worldwide increase in oil prices and domestic inflation at about 0.6 percent. However, the central bank cautioned that interest rates will remain at low levels and that adjustments will proceed slowly. The target appears to be a call rate between 0 and 2 percent. Economists expect the rate to gradually increase toward 2 percent during the next couple of years (Hayashi (2006)). The ten-year JGB has increased in yield from about 1.5 to 2.0 percent in a year. The improving outlook for business together with the upward shift in the yield curve is motivating issuance of debt securities (Morse (2006)). In 2005, Japanese companies placed $62.9 billion of bonds. While placements in the first half of 2006 declined from $31 billion to $27 billion relative to 2005, the number of issuers increased. With the call rate expected to rise to 0.5 percent by year end, the issue of corporate bonds may increase in the second half of the year. The Tankan survey suggests an increase in investment of 11.6 percent by Japanese companies in the second half of 2006. There has been active debate on the merits of monetary policy in Japan. In addition, there are multiple proposals of how to conduct monetary policy to effectively eliminate deflation. The balance of this section provides a survey of some of the research on Japan’s monetary policy. Baba et al. (2005) and Ito and Mishkin (2004) describe monetary policy in Japan. The initial policy consisted of lowering the overnight call rate from 0.43 to 0.25 percent in September 1998 and then to zero in March 1999. In April 1999, the BOJ announced a policy of maintaining the interest rate at zero until deflation disappeared. The economy recovered, growing at 3 percent in 1999–2000 to fall into deep recession because of the global decline in demand for high-tech goods. In March 2001, the BOJ began to target large current account balances, or excess reserves of banks at the BOJ, until the core CPI stabilizes at zero or becomes positive. The BOJ announced that it would purchase JGB as required to maintain the target of current account balances. In October 2003, the BOJ announced its commitment to providing sufficient current account balances until inflation became zero or positive. The BOJ has engaged in open market purchases of bills, commercial paper,

102 The Global Recession Risk

treasury bills and government bonds to maintain the target of JPY30–35 trillion of current account balances. The required reserves are substantially lower at about JPY6 trillion. Subsequently, the BOJ began to also use asset backed securities. Table 3.6 in the Appendix shows the increases in the guideline of current account balances. The decline of asset prices of borrowers has an adverse effect on investment. The decline in the net worth of lenders reduces the loans. These two effects explain most of the decline in lending by banks after 1995 and were reinforced by bank liquidity problems in 1997–98. Thus, there has been a negative financial accelerator effect. Japan experienced a credit crunch after the Asian crisis of 1997–98 followed by the Russian crisis and LTCM in 1998. Japanese banks were not able to solve their NPLs earlier because of this credit crunch. Banks had to recall loans and even large firms experienced difficulties. The policy prescription for debt deflation as in the 1930s is to transfer income to debtors with sound projects. There is a problem of identification of such projects. There could be a similar transfer to banks. The case of Japan is more complex, combining excesses during the 1980s, deflation of asset price and the interaction between the financial sector and the economy. Von Peter (2005) contributes a model of debt deflation. His survey of earlier work considers the contributions by Fisher (1933), Minsky (1982) and Bernanke (1983). Fisher emphasized the feeding mechanism of debt deflation. Debtors engage in distressed selling when they feel they are excessively indebted. The stress of repayment causes a monetary contraction that lowers spending and creates another round of deflation. The decline in prices increases the real value of the obligation, affecting sharply borrowers, as Fisher (1933, 345) affirmed: “The more the debtors pay, the more they owe.” Minsky (1982) introduced the effect of asset prices. He argued that the unwinding of debt through distressed selling lowers asset prices, creating capital losses and further distressed selling. The capital losses reduce spending, generating more deflation. Bernanke (1983) identifies bank credit as a propagation mechanism of debt deflation. He does not intend to show how deflation begins but rather to identify an important mechanism of propagation. Deflation causes significant stress on debtors who experience an increase in the real value of their debts. The default of creditors affects the banking system. Banks contract credit, which causes a decline of spending and further deflation. Von Peter illustrates the three mechanisms of propagation.

Japan after Deflation 103

The magnitude of asset price decline has influenced Japanese thought on monetary policy. Okina and Shiratsuka (2002) consider the emergence, expansion and bursting of Japan’s asset price bubble since the 1980s and its implications for monetary policy. They define a situation of normalcy, where asset prices are aligned with “economic fundamentals.” In this case, fluctuation of asset prices would not constitute a problem for monetary policy. The asset price “bubble” occurs when asset prices diverge from economic fundamentals. In a more benign case, the bubble may originate in excessively optimistic views on asset prices that diverge from what should be a correct view on the basis of more careful assessment of fundamentals. The authors argue that there will be a correction when asset prices contain an element of a bubble. Fluctuations in asset prices that contain a bubble can affect economic activity through the wealth effect on consumption and through changes in collateral and net asset value on investment. There are positive effects on consumption and investment that are not warranted by more accurate prospects of economic fundamentals. The adverse effects of a bubble occur through an unexpected decline of asset prices. The Japanese experience shows clearly that the effects of a bubble are stronger during the bursting than during the expansion. Okina and Shiratsuka argue that in Japan there was euphoria, in the form of excessively optimistic expectations on the economy, during several years. The markets could not discern if a new era was arriving or that if all was simply euphoria. The authors conclude that the central bank could not have solved this puzzle. Including asset prices in the targets of the monetary authorities would not have prevented the disaster that followed. It should be recognized that the concept and theory of the “bubble” require further research and refinement. Ito and Mishkin (2004) argue that in a linear policy model, two targets such as inflation and asset prices require two instruments, but there is only one, the overnight call rate for interbank deposits. Bernanke, Reinhart and Sack (2004) analyze two “non-standard” policies of Japan. The BOJ engaged in a zero-interest-rate policy in the form of a commitment to maintain the call rate at zero until deflation is eliminated. In the second policy, the BOJ followed a quantitative easing, maintaining bank reserves well above the levels required to fix the policy rate at zero. The common instrument of monetary policy in industrial economies is the nominal short-term interest rate, such as the fed funds rate in the United States. The nominal interest rate of currency is zero. Thus, the nominal interest rate cannot be lowered below zero because

104 The Global Recession Risk

currency can be used as a store of value. When the nominal shortterm interest rate reaches zero, the real short-term rate equals the negative of inflation expectations and could be excessive to maintain price stability and full employment. If the real interest rate becomes too high, it could cause lower costs and prices, resulting in an even higher real rate and a new round of deflation that could be difficult to control. Bernanke, Reinhart and Sack found evidence that the yields in Japan significantly declined after the quantitative easing policy relative to those predicted by a term-structure model. They found a similar result for the zero interest rate policy. Ito (2004b) reports proposals by economists for a more aggressive monetary policy. The BOJ would purchase real assets, such as equities and real estate. However, the monetary authorities did not implement these measures. Another possibility could be exchange rate depreciation to reverse deflation. However, the yen has shown a trend of appreciation. In 1981–1992, the rate of growth of GDP of Japan was 4.4 percent per year on average. The rate declined to 1.1 percent per year in 1992–2002, a sharp reduction in growth of 3 percentage points. The Japanese economy was 30 percent of the United States in 1985 and 70 percent in 1995, mostly because of the appreciation of the JPY/USD rate from 260 to 80. In 2002, the Japanese economy was 40 percent of the United States because of slow growth and deflation. Stock prices and land prices quadrupled in the 1980s. Developers, real estate companies and construction companies acquired land with bank loans. Land values collapsed causing pressures on borrowers and lenders. The banks pushed forward the loans in expectation of an increase in land values that did not occur. Eventually, the loans had to be written off or forgiven. The decline in asset prices affected most economic activities in Japan. The policy of quantitative easing faces some difficulties in the form of chronic undersubscription of open market operations of the BOJ (Ito (2005)). The maintenance of excess bank reserves, or current account balances, of JPY30–35 trillion relative to required reserves of JPY6 trillion, requires continuing open market purchases of short-term government securities. The BOJ Governor Fukui was influential in raising the target of current account balances in a meeting of the BOJ Policy Board. The BOJ committed itself not to exit the quantitative easing until the inflation rate, as measured by the CPI, is zero or above for a few months and the majority of the members of the BOJ Policy Board believes that the economy will not fall back into deflation.

Japan after Deflation 105

However, the bids have not been sufficient for the needs of the quantitative easing. Ito (2005) raises the issue that the insufficient bids in open market purchases could signal the inability of the BOJ to maintain current account balances of JPY30–35 trillion. Lowering the target of current account balances could signal to the markets that the BOJ is abandoning easing and may consider tightening. Ito (2005) considers three possible alternatives for monetary policy. The BOJ could pay interest on current account balances, which currently receive no interest. However, interest payments on excess reserves could be interpreted as relaxation of the policy of quantitative easing. A second option would be more aggressive open market purchases. The BOJ could increase its monthly target of purchase of bonds, which has been at JPY1.2 trillion since October 2001. In addition, the BOJ could add riskier securities, such as corporate bonds, real estate investment trusts (REIT) or exchange-traded funds (ETF), to its open market purchases. This would increase the prices of riskier securities and probably lower the yields of longer-term securities, having a stronger impact on the economy. Ito (2005) defends a third alternative, which would consist of replacing the quantitative target with a price level target. Currently, the policy of quantitative easing commits the central bank to postpone tightening. However, it does not inform the markets the level at which the BOJ would consider prices to be stable. The BOJ would establish a price level target and a deadline to attain it. Ito gives an example of such policy: attain inflation of 1–3 percent per year by 2006. In this alternative, even if excess reserves fall below JPY30–35, it would signal to markets the abandoning of the anti-deflation posture. Iwata (2005) interprets the quantitative easing, or bank reserve target policy, beginning in March 2001, as an implicit price stability target. The reason is the commitment of a time frame of implementation of the policy until attaining price stability. In his view, the earlier policy of zero interest rate, from February 1999 to August 2000, failed partly because of the weak commitment on its duration. Iwata summarizes the three conditions of the commitment of the BOJ as: “stably above zero of the core consumer price index on a year-to-year basis or never return to deflation.” The BOJ sent a signal to the markets that it will attain positive inflation rates, without specifying a numerical upper limit. The objective is to provide an anchor of price stability under the bound of the zero nominal interest rate. It is important for the central bank to provide this anchor because of the loose relation between the price level and inflation when interest rates reach zero. The BOJ experienced

106 The Global Recession Risk

difficulties in maintaining the target of current account balances because of lower demand for excess reserves by banks. There was continuing under subscription of money market operations. The BOJ scenario was an increase of the core CPI by 0.3 percent in 2006. Iwata observes that euroyen interest futures anticipate an exit of the quantitative easing. Reinhart (2004) argues that in an economy closing on the zero bound, the goal of a zero interest rate may be too low. A central bank could rapidly reverse the easing policy if inflation threatens again. Another important lesson is that the short-term policy rate may not affect markets. What matters is the current value of the short-term rate and its expected future path, which are implicit in capital valuation and affect spending decisions. The central bank may persuade investors that the interest rate may stay low or even trade lower during a significant period. The distressed situation of Japan under deflation is a valid argument to focus on monetary/fiscal coordination but without future neglect of microeconomic reforms (Bernanke (2003a)). In 1998–2003, the cumulative decline of the implicit deflator of GDP was 9 percent, of the CPI 5.5 percent and of wages and salaries 4.5 percent. Bernanke observes that the BOJ law of 1998 determines price stability as the main objective of the BOJ. He proposes that the BOJ adopt a price-level target. In an initial reflationary phase, the policy would be to reverse deflation and recover the price-level gap or restore prices to what they would have been if price stability had been maintained. In the second phase, policy would be framed to maintain a low rate of inflation, taking into account the measurement errors of the price index that may overstate inflation by 1 percentage point. A second set of policies would attain monetary/fiscal coordination with further purchases of government debt possibly with tax cuts or other fiscal stimulus. If the policy of reflating the economy is successful, the BOJ would have substantial interest rate risk in its portfolio of JGBs. Thus, strengthening of the balance sheet of the BOJ would be appropriate. A conversion of the fixed-rate bonds into flexible-rate ones would be one of various possibilities. Ito and Mishkin (2004) criticize monetary policy in Japan, especially in 1998–2003. In particular, they argue that the interest rate increase in August 2000, during deflation, was “a serious mistake.” In their view, the management of expectations is the key to eliminate deflation. Pricelevel and inflation targets are more suitable for monetary policy during deflation. An inflation target of 1–3 percent could reverse expectations of deflation into expectations of inflation. Ito and Mishkin also believe

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that central banks could consider non-conventional monetary policies, such as purchasing long-term bonds, foreign-currency denominated bonds and NPLs. There is still not sufficient knowledge of the channel of transmission of non-conventional monetary policies.

Exchange rate intervention There has been concern in the major industrial countries about the interventions by Japan in the JPY/USD rate. In a few occasions, the United States and Japan coordinated the intervention. The foreign exchange reserves of Japan increased from $204 billion in 1995 to $838 billion in 2004. It does not appear that Japan intervened to gain an advantage in international trade. The prime motive of intervention was to avoid appreciation of the yen that could create difficulties in the elimination of deflation. Depreciation of the currency could be inflationary and was an avenue in some countries to escape the worldwide depression of the 1930s. The central banks of the major industrialized countries ceased intervention in foreign exchange markets, with the exception of Japan (Chaboud and Humpage (2005)). The MOF of Japan, with the BOJ as its agent, has continued exchange rate intervention. The Japanese monetary authorities conducted foreign exchange rate interventions in 340 days between April 1, 1991 and March 31, 2004. The purchase of dollars, to prevent or slow an appreciation of the JPY, was the objective in 90 percent of interventions. There was a wide range in the interventions, from a purchase of $1 million on November 21, 2003, to a sale of $20.4 billion on April 10, 1998. While the median value of intervention was $695 million, the median dollar purchase, $789 million, significantly exceeded the median dollar sales, $232 million. The United States and Japan intervened jointly in 22 cases. Most of the coordinated intervention was the purchase of dollars. In 1995–2002, the size of the median intervention jumped to $3989 million. However, interventions became less frequent. Between January 2003 and March 2004, the MOF intervened during 126 days, purchasing $315 billion. The median size of the intervention was $1753 million. An intervention is successful according to the criterion used by Chaboud and Humpage (2005) if the market finds forecast value in the intervention. There is forecast value if the interventions predict accurately, in a statistical meaning, movements of exchange rates. If market participants believe that the interventions have forecast value, they could alter the expected distribution of exchange rate changes. The

108 The Global Recession Risk

interventions are automatically sterilized because the BOJ uses reserves of the MOF. The BOJ prevents interventions from altering its monetary policy objectives. In the empirical study, an intervention is successful if the frequency of the pattern associated with it exceeds the frequency irrespective of intervention. The authors found that interventions did not have forecast value of the sign of daily movements of the JPY/USD rate. However, they found forecast value in the form of higher actual than expected frequencies with respect to two events, moderation and reversal of daily JPY/USD rate movements. Size matters in that forecast value is higher for the larger interventions in 1995–2002. The combined US/Japan intervention had only slightly better forecast value. In conclusion, the interventions had modest impacts. The foreign exchange interventions of the BOJ on behalf of the MOF amounted to JPY35 trillion in January 2003–March 2004, equivalent to 7 percent of GDP (Ito (2004a)). In January 2003, Japan faced difficult macroeconomic conditions. There were several major banks close to insolvency. Stock prices were collapsing and inflation was worsening. The objective of intervention was to prevent appreciation of the JPY. During the last decade, growth was 1 percent per year compared with 4 percent from the mid-1970s to 1992 (Ito (2004a)). An analysis of the meetings of the BOJ shows significant concern about the weakness of the economy in June 2001–May 2002 but non-optimistic views until September 2003. During the strong intervention in September 2001, the JPY appreciated by 4.7 percent in the prior month while GDP growth was negative and stock prices declined by 20 percent in May–August 2001. GDP growth had been negative for four consecutive quarters. The JPY had appreciated by 10 percent in the prior three months. The interventions in September 2001–June 2002 by BOJ governors Sakakibara and Kuroda were large in size (Ito (2004a)). In the period of BOJ Governor Mizoguchi, after January 2003–March 2004, the economy improved. Interventions became known as “stealth operations” because they were not announced or confirmed. The market learned of interventions with a lag from the BOJ account linked to intervention. The target was to maintain the JPY/USD rate in the range of 117–120. The Nikkei stock price index declined to 7600, or about 20 percent of its level 13 years before. Bank balance sheets deteriorated because of holdings of equities. Although GDP growth exceeded 4 percent in the second quarter of 2003, the information did not reach the public until August. The JPY/USD rate appreciated from 119 in early 2003 to 107 at the end of 2003. The objective of intervention was

Japan after Deflation 109

to prevent the economy from losing its growth momentum. Information of growth of 7.6 percent in the fourth quarter of 2003 and 6.4 percent in the first of 2004 became available with a lag. There was no intention in the interventions in hurting trade with the United States or the EU. Eventually, the JPY/USD rate appreciated after G7 warnings on flexibility and the market perceived a target of preventing appreciation below 103. The Japanese authorities designed the interventions to prevent worsening deflation and economic conditions.

Structural reform The IMF identified structural rigidities that restrain economic growth in Japan, preventing efficient allocation of resources (International Monetary Fund (2005Jul26)). These rigidities have prevented productivity growth. The labor markets require clear rules for dismissing workers and encouraging participation of women in the labor force. There should be efforts to increase competition in product markets by means of more severe penalties for anti-trust violations as well as diminished regulation. Another set of measures would encourage inward FDI that could facilitate corporate restructuring. There is discussion below of some of the major challenges of structural reform of Japan: the effects of the ageing of the population, the inefficiency of agriculture, the home bias in investment and the low profitability of banks. The national income accounts of Japan show a decline of household savings from 18 percent in 1981 to 6 percent in 2002 (Hali (2005)). Japan is no longer a big saver relative to other OECD countries. According to the life-cycle model, households save during their working years to finance their retirement. Thus, the higher the ratio of older relative to younger population, the lower is the savings rate. In Japan, the population aged 65 or more is 28 percent of the population aged 20–64. The IMF study projects that savings rates in Japan will continue to decline in the future because of the ageing of the population. Agriculture contributes only about 1 percent of GDP in Japan. However, agricultural structure and policies constitute an important distortion of efficiency (McDonald (2005)). Japan is relatively open to trade in non-agricultural products with an average most-favored nation tariff of 3.7 percent for non-agricultural products. There is only an exception of relatively high protection for footwear. The producer support estimates, or subsidy, of agriculture stood at 58 percent in 2001–03, much higher than 35 percent for the EU and 20 percent for

110 The Global Recession Risk

the United States. Most of the subsidy, 90 percent, is by price support measures in the form of import barriers and administrative prices. The equivalent tariff of the Japanese import barriers is 58 percent. Moreover, there is heavy expenditure in public works projects for agriculture. The age of agricultural workers is much higher, with few young people in the sector. These agricultural structure and policies lock productive resources in agriculture that could be used more effectively in other activities, raising the economy’s productivity. An important issue in international macroeconomics is the home bias puzzle, defined as “the contradiction between the obvious benefits of holding a globally dispersed set of equities and the apparent reluctance to do so” (Obstfeld and Rogoff (1996, 304–5)). The increasing dissemination of information on foreign investment opportunities is eroding home bias. A measure of home bias, from the international capital asset pricing model (CAPM), is “the share of foreign assets in the domestic portfolio, divided by the share of the foreign market(s) in the world market” (Walker (2005, 44)). A ratio of 1 would be equivalent to no home bias. The lower the ratio, the higher is the home bias. The ratio for Japan is still high relative to other countries. The diversification of Japanese investment portfolios away from home bias would have resulted in a much better risk/return profile. Regulatory changes since the “financial big bang” in 1997–8 have contributed to reducing home bias. Japan finally stabilized its banking system. NPLs in major banks declined from 8.4 percent in 2001 to 2.9 in 2004 while the capital ratio rose from 10.8 to 11.6 percent (Wolfson (2005)). The improvement in regional banks was more modest, a decline in the ratio of NPLs to total loans from 8.0 to 5.5 percent and an increase in the capital ratio from 9.3 to 9.4 percent. In the past ten years, loan losses in banks (write-offs and higher provisions) were JPY60 trillion. Capital gains in bonds resulting from lower interest rates partly compensated credit losses. However, an important problem remains: the low profitability of Japanese banks. Core profits of Japanese banking have been about JPY2 trillion since 1994, about 0.25 percent of total assets. In the past few years, the ratio of core profits to assets has increased to 0.4–0.5 percent. To be sure, Japan has faced deflation, which causes multiple problems to clients as the real value of debt obligations increases. However, econometric research shows that core profits are not significantly related to the business cycle (Wolfson (2005)). Low profits originate more in weak revenue than in costs, with tight interest margins and scarce non-

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interest income. The share of postal savings of 25 percent of total deposits is another distortion. There is no econometric relation between core profits and the activities of Japan Post, the largest financial institution in the world. Japan Post has a network of 25,000 branches compared with 13,000 for major and regional banks. Moreover, the postal savings system has been a source of political power. The adverse vote on privatization of Japan Post in the lower chamber resulted in one of the most intense political episodes in recent Japanese history. In short, strengthening the financial system is a key structural reform in Japan. Banks provide forbearance lending when they refinance all or part of the loans, or even increase them, to borrowers that they consider as unlikely to repay their outstanding loans (Sekine et al. (2003)). There is a hurdle in using this definition empirically because the bank’s view of the borrower is not observed. Sekine et al. (2003) conducted an econometric analysis of forbearance lending in Japan. They concluded that this lending behavior did occur in Japan, suppressing the profitability of non-manufacturing firms. Banks increased loans to firms with debt ratios exceeding certain levels, especially to segments in construction and real estate after the decline in asset values. The firms that received the loans experienced lowering profitability. The practice of forbearance lending affected Japanese economic growth in addition to the effects of the credit contraction in 1997–98 resulting from the NPLs. Forbearance lending supports inefficient firms and prevents them from becoming more efficient and profitable.

Conclusion The report of the 2005 Article IV consultation of the IMF for Japan identifies the policy challenges of Japan as deflation, fiscal imbalances, low-trend growth and an ageing population (International Monetary Fund (2005Jul26)). Although the output gap is tightening, Japan is experiencing deflation. The IMF’s baseline scenario was for Japanese growth to slow toward potential, growing at 1.5 percent per year (International Monetary Fund (2005Jul26)). Modest improvement in total factor productivity, 1 percent, capital input growth, 0.75 percent, and the ageing population impact on labor input, –0.25 percent, determine this low growth rate of potential GDP. Japan lags other major industrial countries in growth of potential output by 1 percentage point. The IMF suggests that Japan should consider policies to increase

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total factor productivity and diversify the labor force to improve its growth prospects. This scenario assumes decline of savings relative to investment because private savings decline as a result of the ageing population while corporate savings remain stable. However, the increase in public savings over investment stabilizes the current account at present levels. The Japanese economy has been growing during the past four years, the longest period of expansion in the post-war period (Citrin and Wolfson (2006)). Exports provided the initial impulse for growth followed by increased private investment in consumption and investment. The 2006 baseline projection of the IMF (2006May24) for the Japanese economy is growth of real GDP of around 2.75 percent in 2006 and 2 percent in 2007, with inflation increasing moderately to 0.8 percent in 2007 as actual output grows closer to potential. The Fund projects that the current account surplus will remain at about 3.75 percent of GDP in 2006–07. There could be risk of higher inflation resulting from the volatility of world commodity prices and a possible strengthening of private consumption and investment. In the medium-term, the IMF projects the Japanese economy to expand at about 1.7 percent per year with inflation rising slowly to reach 2.0 percent by 2011. The current account would continue to show a surplus of more than 3 percent of GDP but the trade surplus would decline from about 2 to 1.4 percent of GDP. The IMF and Japan differed on the magnitude of the required fiscal adjustment (International Monetary Fund (2005Jul26)). The Fund proposes a stronger fiscal adjustment, consisting of a primary surplus, excluding social security, of 7 percent of GDP in 2005–13. There are different paths of adjustment according to different scenarios of growth. However, it is clear that Japan requires strong measures to cope with its fiscal imbalance and high debt/GDP ratio. Batini et al. (2005) use the GEM of the IMF to probe the effects of the adjustment of Japan on its economy and on other countries. They consider three scenarios:

Characteristics

Baseline

Total factor productivity Δ

1.5

Fiscal deficit reduction rate as % of GDP:

–0.5

Government debt/GDP in medium-term

150

1st Scenario

2nd Scenario

2

2.5

0.25

0.25

110

110

Japan after Deflation 113

The simulations also assume that Japan does not experience deflation and that monetary policy is effective. The higher increase in total factor productivity in the alternative relative to the baseline scenarios, combined with fiscal consolidation, reduces the debt/GDP ratio without significant impact on domestic economic growth and the rest of the world. An important identity in national accounts is that (Lebow (2004, 8): Government spending less tax receipts plus net interest payments on the consolidated net debt of the government and central bank equals changes in the consolidated net debt of the government plus an increase in base money Thus, the proper concept of the public sector debt is the consolidated government and central bank net debt. In 2003, the OECD estimated that the gross debt of Japan was 157 percent of GDP. However, the holdings of financial assets, in the form of 78 percent of GDP must be deducted to obtain a net debt of 79 percent of GDP. There are various factors that cloud even more the fiscal situation of Japan: an ageing population with future social security system obligations, contingent liabilities depending on support of the banking system and quasi-governmental institutions, suspect quality of risky assets denominated in dollar and a high public deficit of 7 percent of GDP. The calculations of Lebow (2004) suggest a possible overstatement of the consolidated debt but without diminishing the need for caution in fiscal affairs on the part of Japan. The easy policy of the BOJ to fight deflation monetized a significant part of the government debt by open market purchases. The holdings of government debt by the BOJ reached 19 percent of GDP in 2003. The consolidated government/BOJ debt was 62 percent of GDP, significantly lower than the net government debt of 79.3 percent, but still a major burden. A future increase in prices by monetary expansion could provide some relief of the debt. Bernanke alerts to the interest rate sensitivity of the BOJ. The Executive Directors of the IMF noted important improvements in Japan: stabilization of the banking system, strengthening of the corporate sector, stronger labor market and beginning fiscal consolidation. However, population ageing and slow growth pose risks to Japan. In addition, the public deficit is high with an increasing public debt. The directors were split as to the more or less rapid pace of fiscal adjustment (International Monetary Fund (2005Aug8)).

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Appendix Table 3.6 Bank of Japan, date and decision on guideline for money market operations Date

Decision

4/8/2003

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 17 to 22 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more Liquidity irrespective of the above target when necessary to secure financial market stability.

4/30/2003

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 22 to 27 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more Liquidity irrespective of the above target when necessary to secure financial market stability.

5/20/2003

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 27 to 30 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more Liquidity irrespective of the above target when necessary to secure financial market stability.

10/10/2003

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 27 to 32 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more Liquidity irrespective of the above target when necessary to secure financial market stability.

1/20/2004

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 30 to 35 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more Liquidity irrespective of the above target when necessary to secure financial market stability.

5/20/2005

The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 30 to 35 trillion yen. For the time being, given that significant uncertainty including geopolitical risks is likely to persist, the Bank will provide more liquidity irrespective of the above target when necessary to secure financial market stability.

Source: Bank of Japan, http://www.boj.or.jp/en/stat/sk/ske.htm#s

Japan after Deflation 115

The replacement of the quantitative monetary framework with a postdeflation approach had been recommended by the IMF (2006May24). The Fund also concurred with the maintenance of the zero interest rate until risks required a more active monetary policy. Transparency in the form of effective communication of the policy view and risks would be essential in the new framework. However, the Fund pleaded for a stronger pace of fiscal consolidation of 0.75 instead of 0.5 percent per year to attain an earlier stabilization of the debt to GDP ratio. Adjustment in the period of expansion could prepare the economy for the effects of population ageing. The IMF reiterated the need to boost productivity by reforms of labor and product markets as well as by integrating the economy of Japan with the rest of the world. Japan appears to be emerging from the deflation and stagnation of the lost decade. The elimination of deflation should be followed by microeconomic reforms that would make the economy more productive.

4 The Euro Area

Summary The German elections of September 18, 2005, ended in deadlock.33 The two largest parties, the CDU and the SPD were unable to form a government. The solution is a grand coalition with little hope that there will be a mandate in Germany for meaningful reforms. The economy of the euro area as a whole has structural deficiencies that originate mostly in a “social model” that is not fiscally sustainable. The major countries—Germany, France and Italy—have similar problems. In a recent euro area Article IV consultation, the International Monetary Fund (2005Jul7) expressed uncommon frustration and questioned “whether policies will muster the decisiveness needed to address the area’s still formidable problems.” Europe has declined steadily over many years and did not benefit from the technological revolution of the turn of the century. McKinsey documented in the mid-1990s that France and Germany were significantly below world class in most of the key industrial segments. Germany had lost its historical talent and courage for innovation. A study of the Bureau of Labor and Statistics (BLS) of the United States shows that productivity increases in the euro area occurred mostly before 1973 and that the United States continued on a trend of growth in productivity while Europe fell behind. The European Commission has revived the Lisbon strategy in an attempt to develop Europe as an attractive place where to work and invest. As in all continental efforts, directives at the center may find a diversity of implementation at the national level. The success of a new Lisbon Agenda requires deep reforms in product and labor markets. The elections in Germany and Italy suggest that such reforms may be politically infeasible. 116

The Euro Area 117

The three major economies of Europe—Germany, France and Italy— tightened their public finance to enter into the EMU with deficits of less than 3 percent of GDP and debts of less than 60 percent. Of course, the debt ratio of Italy has been above 100 percent. The EMU only has monetary policy while fiscal coordination proceeded through the Stability and Growth Pact (SGP). In practice, the SGP has not worked as all three major economies quickly breached their deficit ceilings of 3 percent after 2000. In March, the ECOFIN Council reformed the SGP in such a way that Professor Feldstein (2005, 11) argues that: The danger in looking forward is that each country will find ways to rationalize growing fiscal deficits, comfortable in the knowledge that there will be no formal pressure from other EMU countries and that the interest rate effects will be the same for all EMU countries. The failure to obtain popular support for Agenda 2010 in Germany suggests that politicians may not engage in further reforms of entitlements. The economies of the euro area require upfront fiscal consolidation to prepare for the approaching effects of population ageing in the 2010s. There is an important lesson of Europe for other countries that social models end in rigid markets, low growth and unemployment. The United States should focus its fiscal and monetary policies on their merits to increase interest rates to neutral levels while adjusting the fiscal deficit during a cyclical upswing and not on complex proposals to avoid a run on the dollar based on simulation models.

The decline of Germany Germany’s economy has been steadily declining relative to that of the United States over a significant period. Table 4.1 shows a comparison of GDP per capita for the USA, Japan and Germany since 1960. In 1960, Japan had a GDP per capita of 37 percent of the United States and Germany of 78.9 percent. By 2004, although Japan experienced a lost decade in which GDP grew at only 1 percent per year, it still had GDP per capita of 73.8 percent of that of the United States. In contrast, Germany had GDP per capita of 84.8 percent of the United States in 1980 but of only 71.9 percent in 2004. To be sure, there were high costs of unifying the more prosperous West with the East, an important event that biases the comparison. However, the German economy faces not only current difficulties but even more worrisome future challenges, which are discussed below in separate sections.

118 The Global Recession Risk Table 4.1

GDP per capita, Purchasing Power Parity (PPP) dollars of 2002

Year

USA

%

Japan

%

W Ger

%

1960 1970 1980 1990 2004

14,407 19,144 23,594 29,593 38,392

100 100 100 100 100

5,329 12,613 17,400 24,254 28,337

37.0 65.9 73.7 82.0 73.8

11,361 16,024 20,643 25,094

78.9 83.7 87.5 84.8

Germany

%

27,600

71.9

Source: Bureau of Labor Statistics.

Table 4.2

GDP per employed person, PPP dollars of 2002

Year

USA

%

Japan

%

W Ger

%

1960 1970 1980 1990 2004

38,133 47,959 52,984 61,206 80,187

100 100 100 100 100

10,671 24,251 34,722 46,647 55,474

28.0 50.6 65.5 76.2 69.2

24,163 36,591 47,104 55,733

63.4 76.3 88.9 91.1

Germany

%

58,595

73.1

Source: Bureau of Labor Statistics.

The German economy and the euro area in general have not been able to keep pace with the technological revolution of the turn of the century. Table 4.2 provides the comparison of the three countries in terms of GDP per employed person, which is a measure of productivity. Germany rose from 63.4 percent of the GDP per person of the United States in 1960 to 91.1 percent in 1990. However, Germany’s GDP per worker was only 73.1 percent of that of the United States in 2004. The section below on productivity attempts to identify the causes and policy solutions of the lag of Germany. The gap of Germany relative to the United States has increased in the past ten years. The growth rates of GDP per capita and per worker were relatively comparable for the entire period 1980–2004 (Table 4.3). However, the gap in rates of growth of GDP per capita and per worker between Germany and the United States began to widen in the 1990s and continued in the first years of this century. Germany has been having its own lost decade, significantly because of its inability to design and implement required reforms to change its productive structure. This inability is the result of the difficulty in obtaining consensus in an economy with a “social model,” or welfare state, which is no longer fiscally feasible.

The Euro Area 119 Table 4.3

Average yearly rates of growth, % per year

Country

1980–2004

1980–90

1990–95

1995–2000

2000–04

GDP per capita USA Japan Germany

2.0 2.1 1.6

2.3 3.4 2.0

1.2 1.2 1.5

2.9 1.2 1.9

1.7 1.3 1.1

GDP per worker USA Japan Germany

1.7 2.0 1.6

1.5 3.0 1.7

1.5 0.8 2.2

2.3 1.5 1.2

1.9 1.9 0.9

Source: Bureau of Labor Statistics.

Unemployment is an important consequence of the inflexible labor markets and the inadequate productive structure of Germany and other countries in the euro area. Table 4.4 shows the double digit unemployment rates that prevail throughout the member states of the euro area. The drama for many of the unemployed is that they will never find a job in their lifetimes.

Monetary policy The ECB maintained the policy rates of the euro area unchanged at its meeting on August 4, 2005 (European Central Bank (2005Auga)). The minimum bid rate of the main refinancing operations remained at 2 percent, the marginal lending facility at 3 and the deposit facility at 2. The ECB stated that the interest rates in the euro area are at very low historical levels, providing support for economic activity. Moreover, there do not appear to be risks of price increases. The expectation is that there will be gradual, continuing expansion of the euro area economy. Exports will continue to perform adequately because of strong global demand and price competitiveness. Although oil prices reached record levels, domestic indicators show some improvement. The ECB expressed concern on oil prices, weak consumer demand in the euro area and persistent global imbalances. In addition, the ECB urged fiscal improvement in some countries and labor market reforms. The main objective of the ECB is to maintain price stability. Its specific target is to maintain inflation below 2 percent but close to that level. The President of the ECB, Jean Claude Trichet (2005), observed positive economic fundamentals, such as strong global demand and

120 The Global Recession Risk Table 4.4

Rates of unemployment in the euro area

Region

1996–2000

2001–4

2003

2004

2005

2006

9.8 8.3 15 10.7 11

8.4 8.5 15.2 9.1 8.5

8.7 9.1 11.5 9.5 8.4

8.9 9.5 10.9 9.7 8

8.5 9.5 9.2 9.5 7.7

7.9 8.3 8.3 8.8

Euro area Germany Spain France Italy Note: 2006 in May Source: Eurostat.

Fiscal Deficit

Primary Deficit

USD/EUR

Unemployment

Unit Labor Costs

Labor Product

HICP

Indicators of the euro area

Industry

Table 4.5

–0.5 0.4 2.1 1

–2.6 –3.1 –2.8 –2.4

0.9 0.3 0.3 0.6

0.9456 1.1312 1.2439 1.2441

8.3 8.7 8.9 8.6

2.3 2 1 1.1

0.3 0.4 1.3 0.7

2.2 2.1 2.1 2.2

Period 2002 2003 2004 2005

Source: European Central Bank, Monthly Bulletin.

4.6 4 4.26 4.28

–24.6 0.99 1.5 1.39

–16.6 –20.6 17.7 17

–16.5 –3.1 17.2 6.7

Japan

Stock Market Index Euro area

4.92 4.16 4.14 3.44

USA

Japan

2002 2003 2004 2005

USA

Period

Yield of 10-year bonds and stock market index Yield of Ten-year Bond Euro Area

Table 4.6

–8 20.1 11

Source: European Central Bank, Monthly Bulletin.

earnings, which could affect positively economic activity in the euro area. The euro economy continued to show soft conditions, as verified by growth of GDP of 0.3 percent in the second quarter of

The Euro Area 121

2005 relative to the first. The staff of the ECB projected growth of real GDP of the euro area of 1.0–1.6 percent in 2005 and 1.3–2.3 percent in 2006. The Harmonized Index of Consumer Prices (HICP) increased by 2.1 percent in August relative to 2.2 percent in July. Trichet believed that the inflation rate will oscillate around those levels during a few months. The staff of the ECB projected HICP inflation of 2.1–2.3 percent in 2005 and 1.4–2.4 percent in 2006. There are risks in these forecasts originating in future increases of oil prices, administered prices and indirect taxes. The short-term indicators of the euro area, Table 4.5, support the position of the ECB. The HICP remains at around 2 percent per year. The ECB is a young institution, with only five years of history. To be sure, the staff has some of the most experienced central bankers in the world. However, there is the credibility issue of whether they can work together to design and implement the monetary policy of a diverse set of countries, with a history of conflict. Although industry is recovering in the euro area, the recovery is incipient and is challenged by the risk of higher oil prices and the appreciation of the currency. The fiscal deficit for the region as a whole is close to 3 percent of GDP. Although there is a common monetary policy in the region, there is a much more loose fiscal coordination within the less tight SGP. Although the United States has been increasing interest rates, there may not be the possibility of a worldwide collapse of bond prices as in 1994. In fact, bond yields have not fluctuated as widely as in that period, as shown in Table 4.6. The discussions of the IMF and the euro area revealed different points of view on key issues (International Monetary Fund (2005Jul7)). The IMF and the ECB agreed on the baseline projection of inflation for the euro area but the Fund found that a rate cut should be considered if growth were to diminish. The ECB believed that the risk is of higher inflation because of increases in oil prices, administered prices and indirect taxes while the IMF was concerned with the fading economic recovery. The IMF estimates that the increase in oil prices since the middle of 2003 reduced GDP growth in the euro area in 2004 by 0.5 percentage point of GDP and may have the same impact in 2004 (International Monetary Fund (2005Jul7)). In addition, the appreciation of the euro deducted 0.5 percentage point from growth in 2004. The IMF observes weak internal demand in the euro area, with the impulse from growth originating in global markets. Central banks have been concerned in 2004–05 about the impact of energy prices on inflation (BIS (2005)). United States monetary policy

122 The Global Recession Risk

has been vigilant not only because of oil price increases but also because of the depreciation of the dollar. However, the rate of core inflation at 2 percent per year and modest pass-through of depreciation to internal prices reduced the need for stronger policy measures. The ECB faced the increase in oil prices with inflation at about the 2 percent floor. The policy rate was not increased because there was still no evidence that increases in energy prices were setting pressure on the core index of inflation. The BOJ continued its quantitative easing because of the need to eliminate deflation, maintaining the policy rate at zero. The combination of the worldwide increase in commodity prices and strengthening economic conditions led to the tightening of monetary policy by the ECB beginning in December 2005. There have been three rounds of increases of the policy rate by 25 basis points as shown in Table 4.7. The tightening by the FRB and the ECB eventually had an echo in Japan. All three major central banks in the Table 4.7

Interest rates of the ECB Fixed Rate Tenders

Variable Rate Tenders

Marginal Lending Facility

2006 6–15 3–08

1.75 1.50

2.75 2.50

3.75 3.50

2005 12–06

1.25

2.25

3.25

2003 6–06 3–07

1.00 1.50

2.00 2.50

3.00 3.50

2002 12–06

1.75

2.75

3.75

2001 11–09 9–18 8–31 5–11

2.25 2.75 3.25 3.50

3.25 3.75 4.25 4.50

4.25 4.75 5.25 5.50

2000 10–06 9–01 6–28

3.75 3.50 3.25

4.75 4.50 4.25

4.75 5.50 5.25

Source: http://www.ecb.int/stats/monetary/rates/html/index.en.html

The Euro Area 123

world economy have been increasing interest rates. The fear of oil prices is an important issue. According to Bernanke (2004), a sharp increase in oil prices can both reduce the rate of economic growth and create inflation expectations. The effect on growth occurs through a reduction of aggregate demand. The sharp increase in oil prices deteriorates the terms of trade, or prices of exports relative to imports, which is similar to a tax on the United States paid to foreign oil-producing countries. The United States imports most of the oil it consumes. The increase in the expenditures on oil affects spending decisions of households and firms. Higher oil prices work in two rounds. There is an increase in the cost of living, measured by the CPI, which has energy components. There are indirect effects in a second round as firms pass on to consumers the increase in oil prices. Improvements in monetary policy by central banks have restrained second round effects of inflation. Bernanke observes that monetary policy cannot deal simultaneously with the recessionary and inflationary effects of oil price increases. If the monetary authorities raise rates to control inflation, they run the risk of slowing the economy but if they do not raise rates they run the risk of allowing inflation to increase. Bernanke argues that the central bank can anchor inflation expectations with positive effects on the stability of output and employment. Policy significantly depends on the relative rate of inflation at the time of the oil price increase. In addition, oil prices may increase together with other commodity prices. The ECB (2004Nova) calculated the real price of oil in 2004 terms in the first price shock of 1973–74 as EUR58, in the second shock as EUR72 and in October 2004 as EUR39. The percentage price increases were 270 in 1973–74, 187 in 1978–79 and 56 in 2003–04. Moreover, the increases in prices in the 1970s originated in supply disruptions. The current oil price increases originate in a variety of factors. The growth of demand occurred mainly because of rapid growth in the United States and China. The low level of spare capacity exposed prices to shocks. Oil prices affect inflation through various interdependent channels. There are direct effects in the first round because oil derivatives are in the consumer consumption basket. Simultaneously, oil prices are inputs of production, affecting producer prices. In a second round, the increase of consumer prices could raise inflation expectations. The initial round of inflation of consumer prices and higher expectations could interact with wages. Both inflation expectations and rising wages may lead to increases in consumer prices. In the euro area, a 10 percent

124 The Global Recession Risk

increase in euro oil prices results in an increase of energy consumer prices of 1.5 percentage points in six months. There is a direct increase of the index of consumer prices of 0.1–0.2 percentage point because energy has a weight of 8–9 percent in the HICP. There is also an indirect channel as firms pass on to prices the increase in their costs caused by the oil price increase, eventually reaching the consumer price index. However, these indirect price increases may be slower than the direct ones in their impact on the HICP. In a second round, inflation expectations and wage negotiations may cause further inflation. The ECB considers the impact on inflation in the euro area of a 50 percent increase in oil prices as measured by several econometric models. The quarterly models measure an impact on inflation of 0.3–0.6 percentage points in the first year and 0.1–0.4 percentage points in the second year, with minor impact in the third year. The impact on real GDP growth is –0.1–0.8 percentage point in the first year and –0.2–0.2 percentage point in the second year, with minor effects in the third. There are multiple limitations to these models that cast doubts on their reliability. The ECB believes that an oil price increase leads inevitably to a deterioration of the terms of trade of the euro area. Macroeconomic policy could play a major role. Monetary policy could be used to prevent the second round of indirect impacts on inflation. Credibility is quite important in breaking expectations, which could soften the impact on output. The forecasts of the Energy Information Administration (EIA) (2005Aug5) of the United States are not very encouraging (Table 4.8). There does not appear to be a forecast of crude oil, West Texas Intermediate (WTI), below $60 a barrel in the next few years. In three years, the world economy has experienced an increase in oil prices of more than 100 percent. Much the same is true about oil derivatives. Table 4.8

EIA forecasts of oil and derivatives

Product

2003

2004

2005

2006

Δ% 03–06

WTI Crude ($ barrel) Gasoline ($/gal) Diesel ($/gal) Heating oil ($/gal) Natural Gas

31.12 1.56 1.50 1.36 9.51

41.44 1.85 1.81 1.54 10.74

58.77 2.33 2.41 2.09 13.03

63.46 2.40 2.50 2.26 15.33

103.9 53.8 66.7 66.2 61.2

Source: EIA, Short-term energy outlook, Sep 7, 05.

The Euro Area 125

The International Energy Agency (IEA) (2005Aug11) describes the frequent and rapid shifts of the oil market that defy prediction efforts. In particular, there is no stable relation between oil demand and growth in several countries. In the past, the ratio of oil demand growth to GDP growth has been 90 percent but it declined to 65 percent in 2005. The ratio has ranged 35–162 percent. In the United States, the ratio of oil to GDP growth has been about 37 percent on average but the range has been –27–79 percent. Many variables have affected oil demand—weather, price, secondary and tertiary stock movements. There have been also unpredictable changes in the availability of nonoil energy, such as the outages of Japanese nuclear power plants in 2002–03 and of European nuclear and hydroelectric sources. The experience of the past few years has demonstrated the difficulty in managing supply at the margin. When the industry has tight capacity, attempts at managing supply require higher stocks. Total world demand for oil in 2004 was 82.1 million barrels per day (mb/d) of which 49.5 mb/d or 60 percent in the OECD, 25.4 mb/d or 31 percent in North America, 15.6 mb/d or 19 percent in Europe and 8.5 mb/d or 10 percent in the Pacific OECD (Japan and Korea). China consumed 6.4 mb/d or 8 percent. The IEA projects oil demand in 2006 to reach 85.5 mb/d, an increase of 4 percent in 2 years. There would be a minor increase in demand in North America to 26 mb/d or 2 percent. Europe’s demand would remain flat with China growing to 7.3 mb/d, an increase of 14 percent in 2 years. The world is still highly dependent on the oil cartel, Organization of Petroleum Exporting Countries (OPEC), which contributed 34 percent of world supply. There is high vulnerability of events in a country or region. The United States accounted in 1984 for 10.7 mb/d or 34 percent of total imports by members of the OECD of 30.4 mb/d. The EIA (2005Jul19) projects world marketed energy consumption to grow at the average yearly rate of 2 percent in 2002–25, only slightly lower than the actual rate of 2.2 percent in 1970–2002. The year 2002 is used as the base because of the availability of complete data. Emerging countries absorb a significant portion of the projected growth. The projections use the assumption that emerging economies will grow at the average yearly rate of 5.1 percent compared with 2.5 percent for mature economies. World demand for crude oil would increase from 78 mb/d in 2002 to 119 mb/d in 2025, at the average yearly rate of 1.9 percent. Emerging Asia would contribute 45 percent of the increase in global crude demand in the next two decades. Production of crude oil would

126 The Global Recession Risk

increase by 42 mb/d over the 2002 level of 80 mb/d, or an increase of 52.5 percent, at an average yearly rate of 1.9 percent. The OPEC would be the major contributor to the increase in production. The unpredictable event occurred in the form of a hurricane. According to the IEA (2005Sep9), the impact of Hurricane Katrina on the oil industry when it hit the Gulf of Mexico on August 29 was significant. The hurricane interrupted production capacity of 1.4 million barrels of oil per day (mb/d) and interrupted capacity of products of about 3 mb/d (International Energy Agency (2005Aug11)). The preliminary estimates suggest a loss of 38 mb of products and 70 mb of crude. The EIA (2005Sep7) observes the significant share of the Gulf Coast region of the United States in oil production, refining and natural gas. The facilities ship a significant part of their petroleum products, such as gasoline, diesel and jet fuel, to markets in the East of the United States. The damage of Hurricane Katrina to the offshore rigs, refineries, pipelines and ports in the Gulf of Mexico was substantial. The evacuation of thousands of employees, the floods and electricity outages further affected the oil industry. Table 4.9 shows the initial impact of Katrina on oil and derivatives. The initial losses of shut-in were 95 percent for oil and 88 percent for natural gas, declining to 58 percent and 42 percent ten days after Katrina. The IEA asked its members to provide an extra 2 mb/d of oil in 30 days, with one-half coming from the United States reserves. A significant part of oil from outside the US will come in the form of refined products. The EIA produced three scenarios of recovery of the oil industry from Katrina. In all scenarios, normal conditions will prevail only by December. However, all except 0.9 mb/d of oil refinery will be recovered by the end of September. The prices of WTI would decline from $72.05 per barrel in September to $67.20 in December in the slow recovery scenario. In the other two scenarios, prices do not rise above $70 and they converge in all three scenarios in the range $66.50–$67.20 per barrel. The EIA estimates significant aggregate

Table 4.9

Petroleum capacity of the Gulf Coast of the United States

Product Oil production Crude oil refining Offshore natural gas

Capacity mb/d

% Total

Initial Katrina Impact

1.5 8.0 10 bcf/d

29 47 19

–1.4 mb/d –1.9 mb/d –8.8 bcf/d

Source: EIA, Short-term energy outlook Sep 7, 05.

The Euro Area 127

percentage increases of energy expenditures in the winter of October 2005–March 2006: 34 percent in petroleum, 52 in natural gas, 16 in coal and 11 in electricity. The expenditures for 2005 amount to about 8.7 percent of GDP, compared with 6.2 percent in 2002 and the highest since 10.4 percent in 1985.

Fiscal imbalance The ECB (2005Augb) has expressed concern on changes in the SGP that could result in the deterioration of fiscal balances. The Maastricht Treaty that created the EMU provided for convergence of deficits of members to 3 percent of GDP and of public debts to 60 percent of GDP. Monetary policy of a group of countries with the objective of price stability, as it is the case of the ECB, would be much more difficult if various member countries had significant deficits and unsustainable debts. The ECB would have to raise interest rates to prevent inflation, resulting in tight monetary policy and loose fiscal policy, with resulting overcrowding of private economic activity by the funding needs of the government. The data on deficits and debt as percent of GDP, Table 4.10, are quite disappointing. The three major economies of the EMU—Germany, France and Italy—reduced their deficits as percent of GDP to enter into the single currency agreement by 1999. However, after 2001, the euro area as a whole and the three largest economies increased their deficits above the required maximum 3 percent of GDP. There was a resulting Table 4.10

Deficit and debt, % of GDP

Year

Euro Area Deficit

Debt

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

–4.2 –2.6 –2.2 –1.3 0.2 –1.7 –2.4 –2.8 –2.7 –2.4

74.6 74.3 73.6 72.2 69.6 69.6 68.1 69.3 69.8 70.8

Source: Eurostat.

Germany Debt Deficit –3.4 –2.7 –2.2 –1.5 1.3 –2.8 –3.7 –3.8 –3.7 –3.3

59.8 61.0 60.9 61.2 60.2 59.4 60.9 64.2 66.0 67.7

France Deficit

Debt

Italy Deficit

Debt

–4.1 –3.0 –2.7 –1.8 –1.4 –1.5 –3.2 –4.2 –3.7 –2.9

57.1 59.3 59.5 58.5 56.8 57.0 58.2 62.4 64.4 66.8

–7.1 –2.7 –2.8 –1.7 –0.6 –3.0 –2.9 –3.4 –3.4 –4.1

123.1 120.5 116.7 115.5 111.2 110.7 105.5 104.2 103.8 106.4

128 The Global Recession Risk

increase in the ratio of debt to GDP, causing significant frustration at the ECB. There were rules in the SGP to correct deviations of deficits and debts of individual members (ECB (2005Augb)). These rules were essential after the EMU to permit a common monetary policy. The essence of the system was that those members that exceeded the deficit to GDP ratio of 3 percent would implement medium-term objectives (MTO) of fiscal consolidation equal to 0.5 percent of GDP per year. In the reform of the SGP, members submit country-specific MTOs with their stability or convergence program (ECOFIN Council (2005), ECB (2005Augb)). The current debt ratio and potential growth will be used to determine if there is divergence in the “close to balance” or surplus requirement. The countries that have not met their MTOs will move toward them more aggressively during good times, when growth is close to potential, than in bad times, when growth is below potential. Members will be able to deviate from the adjustment path to their MTOs when they are implementing reforms that are cost saving, including increasing potential output, thus contributing to fiscal sustainability. The costs of pension reform can be used for deviation from the adjustment path of the MTO or even the MTO itself. The excessive deficit procedure (EDP) triggers adjustment when the deficit exceeds 3 percent of GDP or even if the debt exceeds 60 percent of GDP. In the earlier system, an excessive deficit would be considered as exceptional if it occurred during a decline of GDP of 2 percent. There could also be exceptionality for a decline of GDP of 0.75–2 percent in case it was abrupt or resulted in accumulation of loss of GDP relative to past trends. The new rules define severe economic decline as a negative GDP growth rate or the accumulation of a loss of output during a period of low growth relative to potential growth. The earlier SGP rule was to take into consideration other “relevant factors” in determining an EDP. The reform includes a large number of relevant factors in the economic position: potential growth, cyclical conditions, the implementation of the Lisbon Agenda and investment in R&D. The relevant factors in the medium-term budgetary situation include: fiscal consolidation in good times, debt sustainability, public investment and the overall quality of public finance. The implementation of a fully-funded pension system could also be a relevant factor in softening the EDP. In the initial system, the correction of an excessive deficit would begin the following year after its identification by a consolidation of 0.5 percent of GDP per year. In the reform, the ECOFIN Council can

The Euro Area 129

alter the deadline for corrective action in accordance with an evaluation of the above relevant factors. The ECB (2005Augb, 66–7) explains the critical importance of fiscal balance rules in a monetary union: In a monetary union among sovereign states, the deficit bias of fiscal policy is likely to be exacerbated. The adoption of a common currency eliminated the exchange rate risk and the associated interest rate risk premium among the participant countries, thus blunting the discipline normally exerted by financial markets on governments’ fiscal behavior. As national financial markets become more integrated, sovereign issuers can draw on a larger and more liquid currency area-wide capital market. A government that increases its deficit will be able to finance the additional expenditure more easily because the cost of the additional borrowing in term of higher interest rates is, at least partly, spread across the entire currency area. Consequently, the spillover effects from deficit spending in one country on other countries are also greater in EMU, making the participant Member Sates’ fiscal policies all the more a matter of common concern. Euro area-wide interest rates cannot be geared to the national economic situation, whereas automatic stabilizers can help to offset any unduly contractive or expansionary effects on domestic demand. However, if deficits and debt are high, the resultant further increase in the deficit may undermine confidence in the future soundness of public finances, which could prompt private agents to save more and thus offset the forces of automatic stabilization. In the view of the ECB (2005Augb)), the SGP consisted of a set of rules that promoted sustainable fiscal policies oriented to stability. Automatic stabilizers would ensure sound fiscal policies within the preventive arm. The corrective arm would prevent the occurrence of excessive deficits. The limit of the deficit of 3 percent of GDP would anchor expectations of sustainable public finance. There was no restriction of national sovereignty in these rules but rather they ensure the success of the monetary union. The ECB provided a simple example of debt dynamics under the reform of the preventive arm of the SGP. A simple equation captures the evolution over time of a country’s debt ratio (ECB (2005Augb, 69)): d(t ) =

d(t − 1) def (t ) 1+ y

4.1

130 The Global Recession Risk

where d is the debt to GDP ratio, y the rate of growth of nominal output and def the deficit to GDP ratio. The ECB analyzed simple scenarios similar to the current conditions of EMU members. A country with high current debt ratio and slow growth would take 15 years to reach the debt/GDP ratio of 60 percent. A country with average debt and growth rate making the 0.5 percent yearly consolidation would reach the 60 percent debt ratio in six years and the 50 percent debt ratio in 15 years. In a country with low debt ratio and high growth, an MTO of 1 percent of GDP would stabilize the debt ratio. The ECB concludes that continuous compliance with the MTO would reduce the debt ratio very slowly in highly indebted countries. The changes in the corrective arm of the SGP may increase fiscal vulnerabilities within the EMU. There is risk that the ECOFIN Council may not consider deficits as excessive because of the changes in the nature of exceptional circumstances and the inclusion of other relevant factors. Feldstein (2005) notes that the EMU consists of centralized monetary policy and decentralized fiscal policy. Such an arrangement can lead to sustained fiscal deficits and a rising debt to GDP ratio. The euro area can only avoid the deficits and uncontrolled rise in the debt ratio by means of an effective fiscal agreement. According to Feldstein, fiscal deficits in an individual country may not cause increases in interest rates or currency depreciation because of the common currency, the euro, and monetary policy, through the ECB. In a country with its own currency, fiscal deficits would cause increases in interest rates and depreciation of the currency. The common currency prevents the effects of the deficits to be realized. The mechanism to anchor the fiscal deficits of individual countries was the SGP. Table 4.11 shows the high fiscal deficits in several EMU countries, including the three major ones. Professor Feldstein (2005, 11) comments on the consequences of the loosening of the SGP: So there is no longer any restraint on individual country deficits. Already five of the 12 euro area countries have deficits that exceed the 3 percent ceiling, with Greece topping 6 percent. And yet the bond market has still shown no tendency to punish those with high deficits or to reward those with low deficits and national debt. The range of 10 year government bonds rates among France, Germany and Spain was still only 4 basis points. The danger in looking forward is that each country will find ways to rationalize growing fiscal deficits, comfortable in the knowledge that there will be no

The Euro Area 131 Table 4.11 Period 2001 2002 2003 2004 2005

Deficits as percent of GDP

France

Greece

Germany

Italy

Portugal

–1.5 –3.2 –4.2 –3.7 –2.9

–3.6 –4.9 –5.8 –6.9 –4.5

–2.8 –3.7 –4.0 –3.7 –3.3

–3.2 –3.4 –3.4 –3.4 –4.1

–4.4 –2.9 –2.9 –3.2 –6.0

Source: Eurostat.

formal pressure from other EMU countries and that the interest rate effects will be the same for all EMU countries. The European Council has done nothing to reconcile the independent fiscal decision making with the single currency. The IMF (2005Jul7) expressed concern that fiscal consolidation is falling behind requirements in the euro area, especially because of the approaching demographic shock, and that the changes in the SGP may thrust its credibility on implementation by the European Council. The IMF recommends that fiscal balance is an appropriate medium-term goal and that countries with fiscal deficit should engage in adjustment of at least 0.5 percent of GDP per year and even more in good times. The IMF believes that the new SGP is less transparent and did not strengthen the preventive arm. Finally, the Fund observed that structural reform programs, such as the Lisbon strategy and the integration of financial markets, may not deliver timely results. The IMF is beginning to experience the frustration of the inaction of Europe (International Monetary Fund (2005Jul7, 6)): Although many dimensional, these symptoms partly reflect a frustration with the size of the economic problems euro-area countries face and the sluggishness of the system in delivering suitable responses. In many quarters, perceptions of and patience with Europe reached new lows during this year’s [2005] Article IV consultations. A more open question is whether policies will muster the decisiveness needed to address the area’s still formidable problems. First, policy decisiveness has been erratic, with the spare of structural reforms of the past few years possibly motivated as much by bad times as the need for a more forward-looking approach. In this regard, the fraying of the consensus on fiscal policies and the shift to water-treading policies in a number of countries does not bode

132 The Global Recession Risk

well. Second, the stresses of the past few years have also led to a rebalancing—embodied in the reformed SGP and the revised Lisbon Strategy—in the respective roles of the center (“Brussels”) and the member states, with more of the responsibility and initiative place on the latter, and with the Council in an intermediate position. Officials point to these arrangements as providing a more realistic and ultimately sounder basis for strengthened policies. Ownership considerations support this view. However, absent stronger policy leadership and surveillance at the national level, these may take time to materialize. The IMF (2005Jul7) estimates that the increase in oil prices since the middle of 2003 reduced GDP growth in the euro area in 2004 by 0.5 percentage point of GDP and may have the same impact in 2005. In addition, the appreciation of the euro deducted 0.5 percentage point from growth in 2004. The IMF observes weak internal demand in the euro area, with the impulse from growth originating in global markets. The IMF believes that the fiscal policies of the euro area are falling behind of the needs for fiscal consolidation. Increasing expenditures of an ageing population will throw government debts in many countries into an unsustainable path. The Fund argues that to avoid future unsustainable debt, budgets should attempt to reach balance by 2010 while there is significant progress in entitlement reforms. Countries with weak budgetary conditions require yearly adjustment of at least 0.5 percentage point of GDP. Past experience is disappointing. There has been no progress in consolidation since 2000 and there is little consolidation in the budgets for 2005 and 2006. The staff of the IMF (2005Jul7) expressed concern that the reform of the SGP’s preventive arm may allow insufficient fiscal adjustment indefinitely. In the reformed SGP, the adjustment of 0.5 percentage point of GDP per year would occur only when output is slightly below or above potential, which is not the case currently, postponing adjustment. In addition, the Fund argues that the method used to measure potential output ensures that the requirement for adjustment will never occur in reality. In fact, the requirement for adjustment of output around potential was not met even at the peak of the 2000 boom. Moreover, another provision exempts a country from adjustment when it engages in reforms that improve long-term fiscal sustainability. The statement on Germany of the IMF (2005Jun28) Article IV Consultation for 2005 identifies three major risks. Germany faces high

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rates of unemployment because of high labor costs and rigidities. Simulations of public finance show that the welfare programs are not sustainable because of the ageing population. Germany should seek to benefit from globalization and the expanded EU. Success in meeting these challenges requires at least a strong effort of fiscal consolidation and elimination of market distortions, especially in labor markets. Germany’s improving growth outlook depends on external markets because of weak internal demand, which would only improve with greater efficiency and flexibility. The overall fiscal deficit is approaching 4 percent of GDP, of which 3 percentage points is structural deficit. There is a long-term decline in the share of labor in national income because of weak labor markets and wage moderation. The revenue base of the government is declining because it depends on wage income. Simultaneously, benefits of unemployment and social transfers maintain high expenditures. The ageing population will further raise expenditures on pension and health care. Fiscal policies are unsustainable because of the limits of the contribution of a declining population. The IMF proposes the elimination of the structural deficit by 2010, which requires fiscal consolidation of at least 0.5 percentage point per year and a continuously growing economy. Germany requires deficit control policies. The government must reduce expenditures and subsidies in a lasting form. Social security benefits must be redesigned relative to what is possible. The wage bill has to be reduced by shifting health care burdens away from payroll taxes. Tax reform should focus on simplification and reduction of payroll taxes jointly with further reforms of labor and product markets. There were several favorable factors in France that were different from others in the euro area: relatively high household savings, profitability in the financial sector, limited number of companies with balance sheet weakness and a strong housing market (IMF (2004Sep21)). These factors explain why domestic demand has been the driver of France’s recovery. France also implemented a set of reforms that boosted consumer confidence, such as pension reform, suspension of a tax on productive assets and minor fiscal reforms to support household consumption. The macroeconomic risks of France are the increase in oil prices, the euro and weak demand in European trading partners. In 1997–2004, health care spending in France increased at the yearly average rate of 4.7 percent. There were many sources of pressure on spending: widening coverage, rise in prices of pharmaceuticals and consultation fees, an increase in the percentage of population closer to

134 The Global Recession Risk

death and increasing service volumes. France approved health care reform in mid-2004 with the objective of attaining balance by 2007. The initial estimates of savings amounted to EUR15 billion in 2007, close to the projection of the deficit without the reforms. However, the staff of the IMF found that the reform was not sufficient to eliminate the estimate of the deficit, which could have been an underestimate. Pension reforms in 1993 and 2003 reduced the projected costs of ageing in France below the average for the euro area. France and the staff of the IMF agreed on the need to reform labor and product markets. The country has low participation and employment rates and is approaching the problems of population ageing. As in Germany, the economy of Italy derived its impulse for recovery from external demand. The IMF (2005Jan12) calculates that the impact of the external stimulus is about 0.75 percentage point, quite significant in GDP growth of around 1.7 percent. However, Italy has been experiencing competitive pressures from exchange rate appreciation. Although there has been strong demand for high-technology products, they are not meaningful in Italian exports while there has been weak demand for its more traditional products. The increase of oil prices threatens Italy’s recovery. While Italy has relatively low energy intensity, measured by primary energy relative to GDP, it has relatively high oil intensity. The staff of the IMF estimates that an increase in the price of oil of $6 per barrel would increase oil expenditures by 0.3 percent of GDP, causing a decline in growth of 0.15 percent. The increase in oil prices may not affect domestic prices because of low pass-through of depreciation to prices and the output gap of 1.5 percent of GDP. Italy’s inflation is about 2 percent per year, somewhat lower than in the euro area as a whole. Italy has had poor fiscal performance. The staff of the IMF (2005Jan12) has been critical of Italy’s fiscal policy. The primary surplus has been declining, dropping below 3 percent of GDP. The authorities have used “one-off measures” to compensate for the increase in spending and permanent tax cuts. Some of those measures have included real estate sales, tax amnesties and one-off taxes. The ratio of debt to GDP above 100 percent is not declining because of the difference of 1.5 percent of GDP between the deficit measure, public sector borrowing requirements (PSBR), and the SGP deficit. Italy systematically misses its budget target. Moreover, although pension reforms increasing the retirement age constitute improvements, the burden of the ageing population will increase yearly pension spending by 2 percent of GDP in the next decades. The staff of the IMF calculates

The Euro Area 135

that attaining fiscal balance or a small surplus by 2009 would require consolidation of 0.75 percentage point of GDP in the next five years. Italy could reduce its debt to GDP ratio below 50 percent with planned privatizations and stronger fiscal consolidation. In a scenario of no structural reforms, the debt to GDP ratio could reach 200 percent of GDP. However, the staff does not observe budget measures that would move the country in the right direction of faster fiscal adjustment.

Productivity and structural reform The United States has been gaining on the other industrial countries in productivity growth. Table 4.12 shows the international comparison of output per hour in manufacturing estimated by the BLS. The United States surged ahead of the other industrial countries in the past ten years. Table 4.12

Output per hour in manufacturing, yearly % change

Year

USA

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

0.6 5.1 2.9 5 3.9 3.4 0 8.0 2.5 0.7 1.4 3 3.9 2.7 5.2 3.7 4.2 4.2 7.0 5.0 8.0 1.0 10.0 9.7

Germany

1.7 1.8 7.7 2.5 2.2 4.9 1.3 –0.4 4.9 0.3 2.1 2.7

Source: Bureau of Labor Statistics.

West Germany

Japan

France

–1.5 1.9 0 4.9 3.4 4.3 0.5 –1.6 3.8 3.4 4.7 2.9 –1.9 0.6 7.2 3.0 3.5 5.9 4.3

1.6 3.2 3.5 0.2 2.0 9.6 0.5 4.5 4.7 5.6 7.0 4.8 1.0 1.7 1.6 7.4 4.6 4.2 0.2 4.6 7.3 –0.1 2.3 11.0

3.6 3.6 5.8 7.2 3.3 5.4 3.3 1.8 5.3 4.3 1.8 3.3 3.1 1.0 7.7 5.1 0.3 6.1 5.1 4.0 7.1 3.9 4.8 1.9

136 The Global Recession Risk

The definitions used by Cobet and Wilson (2002) in their comparison of labor productivity and unit costs in manufacturing for G7 countries are as follows. Labor productivity is the value of real manufacturing output produced per unit of labor input. Real manufacturing output is value added or value of gross output less the value of all intermediate goods and services used in production. Unit labor cost is the cost of the labor input required for the production of one unit of output, that is, nominal remuneration divided by real output. Unit labor costs decline (increase) if labor productivity increases more rapidly (less rapidly) than hourly compensation. As Table 4.13 shows, US labor productivity in manufacturing increased less rapidly than in Japan and Germany in the period 1950–2000. At the same time, unit labor costs increased more moderately in the United States than in Germany and Japan. Most of the increase in Japan and Germany occurred in the period 1950–73 (Cobet and Wilson (2002)). The rate of productivity growth of the United States was relatively stable throughout various periods. However, Japan and Germany attained their highest rates of productivity growth before 1973. The United States accelerated the rate of growth of productivity in the second half of the 1990s with relatively stable unit labor costs. In contrast, Germany and Japan experienced much lower rates of productivity growth and declines in unit labor costs. Only Japan and France in the G7 experienced an increase in the rate of productivity growth in the second half of the 1990s but much lower than the 1.3 percentage points increase per year of the United States.

Table 4.13

Average yearly rates of change of productivity and unit labor costs Unit Labor Costs

Period/Country

Output/hour

National Currency

USD

1950–2000 USA Japan Germany

2.9 6.3 4.7

2.6 1.9 2.9

2.6 4.7 4.3

1995–2000 USA Japan Germany

4.6 3.9 2.6

–0.7 0.7 –7.6

–0.7 –4.3 –7.5

Source: Cobet and Wilson (2002: 54, 61).

The Euro Area 137

The revived Lisbon strategy departs from a message of optimism that the structural problems facing the EU are surmountable and that the strategy can lead to the desired prosperity of jobs and growth (Commission of the European Communities (2005Apr1-Apr29-Jul7)). However, the projection of current conditions shows the strains of the European social model in the future and the need for vigorous action. The ageing of the population will shrink the working-age labor force and increase the percentage of retired people. Potential growth would drop to 1 percent per year by 2040 unless there is a compensatory increase in labor productivity. The lower rate of growth and increasing age-related expenditures would result in “considerable stress.” Europe faces new challenges of competitiveness in globalization. By 2010, investment in R&D would stand at 2.2 percent of GDP, much lower than the target of 3 percent. The objective of the Lisbon strategy is economic modernization to strengthen the European social model. There are challenges of interconnected global markets, technological change, an ageing population and environmental concerns. Meeting present needs should not diminish the capacity of future generations to meet their own needs. Europe must invest in young people, research and innovation to provide economic wellbeing in the future. The strategy is to open markets, reduce bureaucratic hurdles and invest in infrastructure to create the environment for European business to grow, innovate and create new and better jobs. There will be care in maintaining sound macroeconomic policies. The implementation of the Lisbon strategy became the top priority of the European Commission. The original agenda was announced in 2000 with the intention of turning Europe by 2010 into the most dynamic economy based on knowledge. However, there has been insufficient support for structural reforms. While it is true that final authority rests with individual countries, the coordination at EU levels has been weak. In March 2005, the European Council endorsed a reform of the Lisbon strategy. The objective is to create more and better jobs, making Europe a more attractive place to work and invest by spreading knowledge and innovation. There are multiple integrated guidelines for growth and employment for the next three years. Individual countries will prepare national action plans to implement the reformed agenda. The objective of decentralizing the agenda is to encourage ownership by individual countries that could result in more vigorous implementation. However, the staff of the IMF questions if there is sufficient prioritization. The focus of the reform should be on

138 The Global Recession Risk

providing incentives to work, labor utilization and enhanced competitiveness, which would increase European potential output. The reformed agenda creates possibilities of avoiding politically difficult changes by creating 20 broad guidelines. Table 4.14 shows the new integrated guidelines of the European Commission. Denis et al. (2005) explore the inferiority of the EU in productivity growth relative to the United States. They argue that the problem is in the obsolete and inflexible industrial structure of Europe and its inability to change in response to globalization and accelerating technological change. The productivity problems of the EU originate in: concentration on low and medium technology segments, failure to challenge the US in IT and lagging appropriation of benefits in industries using IT. The US has superiority in its innovation system, in both

Table 4.14

European Union, integrated guidelines

Problem Macroeconomic policies Budgetary objectives

Fiscal policy Excessive fiscal deficit Current account deficit Coordination of euro area Microeconomic policies General Technology Competitiveness Competition Horizontal objectives Employment Level Rate Participation Retirement Wages

Guidelines Maintain objectives or take corrective measures in line with The Stability and Growth Pact Avoid procyclical fiscal policies Prompt action to adjust the deficit Structural reforms to improve competitiveness Coordinate monetary and budget policies; policy mix for economic recovery with price stability Deep reforms to improve growth and job creation Allocate 3 percent of GDP to research and development Move EU to high-productivity growth sectors Remove entry barriers Promote research, innovation and optimal use of human capital Ensure full employment Average in EU of 70%, 60% for women, 50% for older workers Increase female participation Increase the retirement age Should reflect productivity

Sources: “The integrated guidelines for growth and jobs 2005–2008,” in ECB Monthly Bulletin 08 (Aug 05); Commission of the European Communities (2005Apr1).

The Euro Area 139

quality and funding of the knowledge sector. The economic and regulatory framework of the US does not inhibit the transformation of excellence in knowledge into competitive industrial activities. There are various factors of the inferiority of the EU in productivity levels: regulation, structure of financial markets, ageing of the population, lack of product market integration and weakness in the knowledge sector. Inflexible markets inhibit productivity (Baily and Farrell (2005)). A key element in the success of the United States, according to Denis et al. (2005), is the highly competitive market, which facilitated the channeling of the technology from the source of knowledge to mass consumption. The US also had world class research and teaching institutions, financing and focused R&D. The success of the Lisbon 2010 Agenda requires major structural changes, including reform of the EU economic and regulatory environment. The EU needs adequate entry and exit rules in markets. Living standards in the EU are only 70 percent of those in the US. Differences in productivity explain one-third of the gap and lower utilization of the labor force the other two-thirds. The productivity level of the EU peaked at 97 percent of the US in the mid-1990s and declined to 88 percent in 2005. The US improved its relative living standards because of a much lower rate of unemployment and a higher rate of growth of productivity. The lag of Europe in productivity was evident by 1995 as documented in a study by McKinsey (Brinker et al. (1997)) of labor productivity, employment and output in seven segments of industry. Germany’s output was lower by 30 percent than the world class, 20 percent below in labor productivity and 15 percent below in employment per capita. France produced 40 percent less goods and services per capita than the world class, had 25 percent less employment per capita and lagged 20 percent in labor productivity. The United States was the world class in five of the key industrial segments and Japan in one. McKinsey concluded that regulations of specific products in individual industrial segments constituted the single most important hurdle to progress in France and Germany. The barriers to competition and inefficiency in government discouraged innovation and the use of more efficient methods, restricting productivity and growth. In both France and Germany, high minimum wages and market regulations restricted production and labor productivity. According to McKinsey, the separation of economic policy from social objectives would improve both the economy and social targets. The data in the

140 The Global Recession Risk

study by McKinsey showed that productivity in France and Germany was 20 percent below world class. In another McKinsey study of the mid-1990s, Kluge et al. (1996) analyzed German industry and its difficulties in maintaining global competitiveness. German companies were losing market share constantly because of their high costs. Corporate restructuring had the objective of attaining competitive costs within Europe to subsequently engage in global expansion. Innovation became very expensive in R&D and of long gestation before producing results. The word processor illustrates the shortening length of the product life. The initial typewriter had a cycle of 35 years, the electric typewriter 20 years and the software a few years to a few months. There were historical times when Germany dominated innovation as in missiles, television, jet planes and bullet trains. The first commercial motor vehicle was German, produced by Benz Patent Motorwagen, as well as x-rays and many other products. German companies contributed only one-half of the value added in a global study of McKinsey of 102 electronic companies in the mid-1990s. Sales of new products, an indicator of success in innovation, accounted for 30 percent of those of innovating companies. McKinsey carefully documented the fall of Germany as an innovator by the mid-1990s. The current labor markets of Germany constitute an important hurdle to the progress of the country. There has been a deceleration in the increase of real wages in the euro area in the past ten years. However, declines in the rate of unemployment or higher growth have not accompanied this wage moderation (Estevão (2005)). The unemployment rate in the euro area remains high, around 9 percent, and GDP growth was on the average 1.9 percent per year in the past decade compared with 2.6 percent in the prior decade. Wage moderation in an economy with high unemployment and pressure for wage increases should lower costs, increase profitability and raise output because of improved competitiveness. The rate of growth of real hourly compensation in the euro area declined from 6 percent in the early 1970s to 1 percent currently but the rate of unemployment showed an upward trend. The rate of growth of real per capita business GDP in the euro area declined from an average 3 percent in the 1970s to 1.9 percent in the past decade. Estevão (2005) estimated a “wage curve,” relating wages and unemployment rates, for 20 industrial countries. He concludes that highlyregulated product markets in the euro area prevent a beneficial impact of reforms of the labor markets on output and employment. There is a

The Euro Area 141

positive association between increases in wages and increases in the rate of unemployment, that is, the wage curve is positively sloped. Wage moderation would consist of a downward shift of the wage curve such that for the same wage level there would be a lower rate of unemployment and higher output. However, the magnitude of the effect of wage moderation on unemployment and output depends on the degree of regulation of product markets. In highly-regulated product markets, existing firms appropriate part of the benefits of an improved labor market in the form of rents because of the barrier to entries and weak competition. The higher regulation of product markets in the euro area relative to the rest of the OECD diminishes the impact of wage moderation on employment and GDP growth. The labor markets of Germany show specific weaknesses relative to those in other major industrial countries. The institutional characteristics are as follows (Kuijs (2004)): • Declining utilization of labor: the average yearly hours worked by a member of the working age population (15–64) declined by 26 percent from 1970 to 2003 • Lower number of hours worked: the number of hours actually worked in 2003 was 37 percent higher in the United States than in Germany, 31 percent in the UK and 24 percent in Sweden. The average hours actually worked in Germany declined by 26.3 percent between 1970 and 2003 • Low participation in the labor force: Germany has a higher difference in labor force participation relative to unemployment than in other industrial countries • Low participation of females, the young and older people: the labor force participation of ages 25–54 in Germany is 85 percent relative to 83 percent for the United States but that of ages 15–24 is only 42.4 percent in Germany versus 61.6 percent in the US and 43.1 percent in Germany for ages 55–64 versus 62.4 percent in the US • High structural unemployment: the non-inflation accelerating rate of unemployment (NAIRU) for Germany in 2003 is 7.2 percent relative to actual unemployment of 9.3 in contrast with 5.3 percent NAIRU and actual unemployment of 5.3 percent in the US • Unemployment higher in East Germany: the unemployment rate of the population of ages 15–64 in May 2003 was 10.5 percent in the whole of Germany, 8.7 percent in the West and 18.3 percent in the East with comparable numbers for women of 9.6, 7.4 and 18.4

142 The Global Recession Risk

One of the reasons for this distorted labor force participation is the net replacement benefits of unemployment insurance. In Germany, a working couple with two children would receive 91–98 percent of its income in unemployment insurance according to whether they earned 50–150 percent of the average worker wage compared with 63–85 percent in the US. Moreover, the terms of assistance are much more generous in Germany than in other countries. The tax wedge of wages consists of income tax, social security contributions and the consumption tax. In Germany, it increased by 10 percentage points since 1969. Kuijs (2004) shows that the tax wedge for a married couple with two children ranges 33.5–46.7 percent in Germany, according to earnings relative to the average production worker. The comparable range for the US is only 15.5–27.2 percent. As a result, labor is more expensive in Germany, restricting employment and diminishing competitiveness. Wage floors accentuate the adverse effect on employment of the tax wedge on poorly remunerated workers. Germany introduced in 2003 the Agenda 2010 with the objective of reforming labor markets. One of the elements of the reform is a ceiling on the duration of unemployment insurance, effective January 2006. There is also an effective reduction of the replacement rate of unemployment assistance affecting some 2.2 million people. There is a tightening of job acceptance requirements and stricter enforcement. Several measures intend to restrain early retirement. Wage moderation continues by some relaxation of labor negotiations. However, there is little progress in reducing the tax wedge because of the legal requirement to fund social security benefits with payroll taxes. A reduction of payroll taxes would require reform of entitlements and lower government expenditures. Kuijs (2004) introduces a preliminary measurement of the impact of the reform. The long-term impact could increase employment by 600,000 or 1.5 percent more employment. Of the total, 400,000 would be in the form of lower unemployment and the remainder caused by higher labor force participation. He warns that the reforms are having a positive impact but that much more would be required to correct Germany’s labor markets. Benedikt (2004) embeds German conditions in a neoclassical growth model to analyze the impact of ageing and reforms of labor markets in GDP growth. The ageing of population in Germany will cause sharp acceleration after 2010 in the decline of the ratio of the working age population relative to dependents (children and elderly). By 2035, the

The Euro Area 143

dependency ratio of Germany will be about 50 percent, twice the current level. The reduction of the labor input will diminish potential GDP growth. Employment would decline by 0.4 percent per year in the 2010s and by 1 percent in the 2020s. Assuming capital productivity improving by 2 percent per year and total factor productivity by 1 percent, potential GDP growth would be 0.5–1.0 percent per year. If the burdens of entitlements are financed with increasing payroll taxes, potential GDP growth could be zero. The recent reforms would raise potential GDP growth by 0.1 percent compared with the scenario of no reforms. An increase in the retirement age would increase potential GDP growth by 1 percentage point. The conditions for sustainability of the welfare state in Germany have changed over time (International Monetary Fund (2004Sep28)). The average rate of growth of potential real GDP was 4.4 percent per year in 1962–70, declining to only 1.6 percent in 1992–2000, with total factor productivity growth declining from 2.0 percent per year to 0.9 in the same period and growth of the capital stock from 7.9 to 2.3. A far less dynamic economy has substantially more difficulty in paying for the entitlements. The IMF (2005Jan12, Sgherri (2005)) estimated the contribution of total factor productivity (TFP) to the rate of growth of GDP in Italy. In the entire period 1960–2004, the average yearly rate of growth of GDP was 3.3 percent with a contribution by TFP of 2.2 percent. However, most of the growth of GDP and the increase in TFP concentrated in the 1960s and 1970. For example, in the period 1960–70, the rate of growth of GDP was 5.7 percent on the average with TFP contributing 4.8 percent. In the period 1991–2004, the rate of growth of GDP slowed to 1.7 percent with a contribution by TFP of 0.5 percent. The staff of the IMF (2005Jan12) identified various labor market reforms in Italy—liberalization of part-time and fixed-term contracts, new role of employment agencies, pension reform and wage moderation—as factors of rapid increases in the employment ratio and total hours worked since 1996. As in the rest of the euro area, there is still need for more flexibility in labor markets. In addition, the staff also observed insufficient competition and excessive regulation in product markets that prevent investment, innovation and efficiency. Italy’s business environment is not conducive to sound economic performance (Lssovolik (2005), Drummond and Friedman (2005)). The indicators of the business climate of the World Bank show adverse effects on investment and growth. For example, the cost of starting a business in Italy amount to 16.2 percent of per capita GDP, much higher than

144 The Global Recession Risk

11.4 percent for the euro area average of the three largest economies. The staff argues that the low level of FDI into Italy reflects its unfavorable business environment. The realization of benefits of financial market integration is one of the fundamental motivations for the creation of a monetary union such as the EMU. The initial measures consisted of a common currency and monetary policy, the elimination of exchange rate risk among the member countries and of restrictions of holding assets (Haas (2005)). However, there is still need of measures to facilitate the access of market participants to the entire market without establishing a local presence and complying with different regulations. The efficient functioning of financial markets and unrestricted cross-border flows would strengthen financial intermediation that could significantly improve efficiency in resource allocation. Although there have been important efforts such as the Financial Services Action Plan and the Lamfalussy Approach, financial integration is uneven and incomplete. The benefits of integration may only be realized in the future.

External balance Table 4.15 shows that the current account of the euro area is near balance. There is a trade surplus of 1.1 percent of GDP. Several countries, such as Germany, are deriving their growth impulse from foreign markets because of flat internal demand. However, as Table 4.16 shows, this is not the case of Germany, which is running a substantial current account surplus. The conclusions of the Article IV Consultations of the IMF (2006May30) underscored the return of optimism on the fundamentals of the euro area. Nevertheless, the Fund emphasized the need to “exploit the synergies between fiscal adjustment, welfare reform, and

Table 4.15

Euro area current account and trade, EUR billion

Year

Current Account

% GDP

Trade

% GDP

Nominal GDP

2001 2002 2003 2004 2005

–3.3 64.5 32.4 49.9 –22.6

0 0.9 0.4 0.6 –0.3

73.3 144.9 125.6 134.3 87.3

1.1 2.0 1.7 1.7 1.1

6,882 7,251 7,459 7,738 7,993

Source: European Central Bank, Monthly Bulletin.

The Euro Area 145 Table 4.16 of GDP

Germany, France and Italy, current account and fiscal balance %

Germany Current account General government balance Structural government balance General government gross debt France Current account Central government balance General government balance General government gross debt

2000 2001 2002 2003 2004 2005

2006 2007

–1.4

0.1

2.2

2.3

3.7

4.1

3.6

4.3

1.3 –1.2

–2.8 –2.7

–3.7 –3.2

–4.0 –3.0

–3.7 –3.2

–3.3 –2.6

–3.3 –2.8

–2.4 –1.6

58.7

57.9 59.6

62.8

64.5

67.5

69.0

68.7

2000 2001 2002 2003 2004 2005

2006 2007

1.4

1.6

1.0

0.3

–0.4

–1.3

–1.9

–2.1

–2.5 –1.5

–2.3 –1.5

–3.9 –3.1

–4.0 –4.2

–3.2 –3.7

–2.9

–2.9

–3.0

56.6

56.1

58.1

62.7

65.0

67.3

67.0

67.0

Italy

2000 2001 2002 2003 2004 2005

2006 2007

Current account Overall balance Structural balance General government gross debt

–0.6 –0.1 –0.6 –1.3 –0.9 –1.5 –1.1 –0.7 –0.8 –3.1 –2.7 –3.4 –3.4 –4.1 –4.0 –4.3 –2.8 –3.9 –3.4 –2.9 –3.3 –3.3 –3.1 –3.3 111.3 108.2 105.4 104.0 103.9 106.3 106.9 107.6

Source: IMF, IMF concludes 2004 Article IV Consultation with Germany. Washington, DC, Nov 2, 2004; IMF concludes 2004 Article IV Consultation with Italy. Washington, DC, Feb 9, 2004; MF concludes 2004 Article IV Consultation with France. Washington, DC, Nov 3, 2004; IMF World economic outlook: globalization and inflation April 2006.

enhancing the efficiency of all markets, whether for labor, capital, goods or—but perhaps especially—services, including financial services. The baseline scenario is for growth of about 2 percent. The rigidity of productivity and the ageing of the population cast a shadow on the future after 2010. Inflation would remain around 2 percent, declining below that level after absorption of exogenous shocks such as oil. Monetary tightening has been adequate but should be extended into the future unless the recovery strengthens. To meet the challenges after 2010, fiscal consolidation should proceed at 0.5 percent of GDP per year. Stronger economic growth of the euro area would help to alleviate global imbalances.

146 The Global Recession Risk

Germany’s economic performance in the past five years has been disappointing. The IMF (2006Jan18) summary of economic indicators shows the weakness of GDP growth:

2001

2002

2003

2004

2005

1.2

0.1

–0.2

1.6

1.0

The outlook is for growth of only 1.5 percent in 2006. The fiscal deficit is about 3.75 percent of GDP with small expected improvements in the future. The decline in wage income has affected revenue, the main tax base, while costs of reforms are higher and savings lower. The unemployment rate is about 9 percent.

5 Currency Crashes

International macroeconomic analysis of emerging country crises has focused on a few analytical approaches: sudden stops (SS) of capital flows, current account reversals (CAR), original sin (OS), debt intolerance (DI) and the balance sheet approach (BSA). The first section considers SS, followed by an analysis of the vulnerabilities of Mexico, with subsequent sections analyzing OS, DI and the BSA. Empirical illustrations and research complement the theory. The lowering of the fed funds rate to 1 percent caused a hunt for higher yields by investors. The Financial Stability Report April 2006 of the IMF shows that the issue of bonds, loans and equities of emerging countries reached $406.4 billion in 2005, an increase by 41.6 percent over the record $286.9 billion in 2004. Gross issue of emerging country bonds reached $182.2 billion in 2005, an increase by 35 percent over the record in 2004. The global EMBI declined in yield spread from 735 basis points in 2000 to 482 in the first quarter of 2004 and to 210 in the beginning of 2006. The theory and evidence show that emerging countries are highly vulnerable to an international event resulting from an exit out of dollar positions accompanied by a rise in interest rates. The wide oscillation of international financial and economic variables—such as exchange and interest rates, output, capital flows and trade—could cause adverse effects on domestic employment and growth in many countries. Crashes of emerging country currencies would magnify their output and job losses. The IMF may not be able to resolve a crisis in several countries because it has only $150 billion of usable resources.

Sudden stops According to a banker’s adage (Dornbusch, Goldfajn and Valdés (1995, 270), in a flight out of assets “it is not the speed that kills, it is the 147

148 The Global Recession Risk

sudden stop.” In a framework of unregulated financial markets, an overvalued exchange rate exacerbates the financial crisis and the contraction of output. In this current of thought, the real exchange rate is crucial. If it reaches a relatively high level, it affects real output, leading to financial instability with an ultimate depreciation. An important assumption in this framework is the effect of inertia of prices, causing a downwardly rigid real exchange rate. Policy should prevent a rise in the real exchange rate because of this downward rigidity. Eventually, a more flexible exchange rate may replace the overvalued real exchange rate. Guillermo A. Calvo and Carmen M. Reinhart developed the important analysis of “sudden stops” of international capital flows and their financial repercussions in a number of essays.34 Abrupt interruption of capital flows forced immediate adjustment of the balance of payments, with disastrous effects on output, characterizing twin crises in the past ten years (Edwards (2004)). Calvo departs from the basic identity of national accounts in a non-monetary economy: KI = CAD

(5.1)

or capital inflow, KI, equals the current account deficit, CAD. For both a monetary and non-monetary economy: CAD = Z – GNP = Z* – GDP – NFTA

(5.2)

where Z is aggregate demand, Z* aggregate demand of tradables, GNP Gross National Product, GDP Gross Domestic Product of tradables and NFTA net transfer of factors abroad. Capital inflow during a period, increase in KI, results in increase of the CAD. The SS of net capital inflow consists of contraction of the CAD and in most cases reversal to surplus, in a very short period. Decline of demand for tradables, without decline of output, can accommodate the decline of the CAD. In practice, given the exchange rate, the decline in demand for tradables occurs with the decline of non-tradables, Z–Z*. In a flexible exchange rate regime, the ratio of the prices of non-tradables to tradables declines. Loans with collateral of non-tradables, such as real estate, experience debt service problems because of the decline of value of the collateral. There is an incentive to default when collateral drops below present value of loans (Friedman (2000b)). The banking sector may experience stress.

Currency Crashes 149

Calvo postulates that the effect of the current account on the contraction of the economy will be more pronounced if the share of consumption goods in total expenditure and, especially, on aggregate demand for tradables is higher. He assumes that consumption of tradables is more intensive in labor than investment in non-tradables. This assumption originates in the productive structure in Asia of light consumer goods intensive in labor. The higher the share of consumer goods in tradables, the higher will be the reduction of non-tradables resulting from lower demand for tradables. Therefore, the higher will be the devaluation or decline in price of non-tradables. The decline in price of non-tradables depreciates loan collateral, such as real estate, deepening banking sector difficulties. In a monetary economy: KI = CAD + RA

(5.3)

where RA is accumulation of reserves per unit of time. Almost all results are still valid. In this case, reserve accumulation can accommodate the lower capital flow, which in practice rarely occurs, especially in emerging market countries. The Fisherian transmission channel can create serious difficulties, according to Calvo and Reinhart. Financial contracts are contingent on few states of nature, such as terms of trade, profits, demand, etc. Bank debt service occurs in installment payments. The analysis departs from an initial regime of a fixed exchange rate with prices of tradables exogenous and constant over time. The SS causes decline of demand and deterioration of prices of non-tradables in relation to tradables.35 Since the interest rate does not change during the SS, the real interest ex post paid by producers of non-tradables increases, causing a higher number and value of past due loans. The devaluation softens the adverse impact because prices of non-tradables need not fall. However, devaluation is less effective because of widespread dollarization in emerging countries. There are dollar-denominated debts even in cases of light dollarization. Loan maturity occurs before project completion. Interest rate increases on renewal of loans, or rollover risk, cause difficulties in companies and, consequently, in banks. Banks in difficulties reduce their loans so that even sound projects do not receive financing because of adverse selection.36 Economic conditions worsen without immediate hope for recovery because of the breakdown of financial intermediation.37 Banks provided loans in expectation of stability of

150 The Global Recession Risk

relative prices of non-tradables to tradables. Deterioration in the terms of trade, price of non-tradables to tradables, generates NPLs and bank difficulties. Calvo and Reinhart provide a link between exchange crisis and the impact on the financial sector through balance sheet effects. Dollarization of liabilities, according to some arguments, originates in moral hazard partially caused by excessive confidence on the fixed exchange rate regime. Flexibility would cause better risk control discipline, avoiding excessive indebtedness in foreign currency. Professors Calvo and Reinhart dispute this argument. Most emerging markets begin from a situation of high dollar liabilities and there are few cases in emerging countries when exchange volatility does not create difficulties. Partial dollarization increases costs of exchange volatility, through the Fisher channel, that motivates the central bank to intervene in the market to avoid fluctuations of the nominal exchange rate, fear of floating, which is turn causes more dollarization of assets. Traditional theory would advise floating the exchange rate for adjustment to real shocks and fixed exchange rates in other cases. However, shocks to emerging market countries originate in capital flows mixing real factors with others (Ahmed (1999)). Fisherian analysis suggests concern with relative price volatility and the real exchange rate and not only with output volatility. Calvo and Reinhart criticize the traditional theory that devaluation promotes external balance with few effects on output and employment. Consider an economy with two sectors, coffee and electronics. Productive resources, including labor, are not homogeneous, as in classical theory. In a short to medium-term period, coffee workers cannot transfer to production of TVs. If coffee price declined 20 percent, given the wages, maintenance of coffee sector employment would require 20 percent devaluation. In turn, devaluation would cause excess demand in electronics and resulting inflation. Devaluation consists of a process of political conciliation among groups of diverse and conflicting interests. According to Calvo and Reinhart, fiscal policy consisting of subsidies to labor could provide effects similar to a real devaluation. Therefore, the extra degrees of freedom alleged for exchange rate flexibility are fictitious or attainable by fiscal policy. There is an informed view that emerging market crises originate in SS of capital inflows (Calvo et al. (2003)). Developing a theory from this conjecture is a difficult task. Ideally, such a theory would relate discontinuities in market equilibrium as a function of market fundamentals.

Currency Crashes 151

However, deterioration of fundamentals of emerging markets has not preceded these crises. The currency crisis may be of secondary importance because the financial vulnerabilities and weak government policy constitute the main causes of contraction of the economy. Calvo argues that countries should carefully monitor the effects of the SS to acquire knowledge on how they affect internal vulnerabilities, improving future crisis management. The main policy should be strengthening fiscal and financial institutions. The International Financial Institutions (IFIs) could have a major role in coordinating private sector bail-ins. In addition, the IFIs can promote fiscal reform, which would promote higher growth. Recent financial crises in emerging market countries cannot be explained adequately with available business cycle models (Calvo et al. (2004)). The internal disruptions in crisis countries started with SS. These SS are associated with large depreciations and disruptions of the financial system, resulting in low rates of return, investment and growth. There is a bunching of SS, which suggests that other approaches, such as weak fundamentals because of fiscal imbalances and currency pegs, may not adequately explain reality (Calvo et al. (2004)). Profound SS occurred in many countries simultaneously with diverse patterns of fiscal imbalances and exchange rate regimes. Thus, SS may have caused the disruption in those countries. The model of Calvo et al. (2004) departs from a simple equation of the demand for non-tradables: h = α + β rer + δ z

(5.4)

h is the demand for non-tradables, rer is the real exchange rate defined as the ratio of tradables to non-tradables, Z is the demand for tradables, the Greek letters are parameters and the lower case letter are natural logarithms. If CAD stands for the current account deficit before the SS, which is negative but becomes positive after the SS, and Y for output of tradable and S for factor remittances abroad, by definition: CAD = Z – Y + S

(5.5)

Assuming that Y and S are fixed, taking first differences of 5.5 and dividing by Z: –ΔZ/Z = CAD/Z

(5.6)

152 The Global Recession Risk

Assuming that h is constant and taking first differences of 6.4: Δrer =

δ CAD β Z

(5.7)

Thus, equation 5.7 expresses the change in the real exchange rate in terms of the CAD before the SS in terms of absorption of tradables. The spirit of the equation is to express not the actual change in the exchange rate but rather of that part of the change that the country cannot prevent. The SS approach of Calvo et al. (2004) argues that the probability of an SS is an increasing function of the ratio CAD/Z and the degree of domestic liability dollarization (DLD). The combination of an unavoidable CAD when capital markets tighten and the degree of DLD generates the conditions for the SS. The sample used by Calvo et al. (2004) contains monthly data for 32 countries, 15 of which are emerging and 17 advanced, in the period 1990–2001. There are interesting empirical characteristics of the SS: • Bunching: the SS concentrated in emerging countries during the Mexican crisis (1994), Asian crisis (1997) and Russian crisis (1998) and around the collapse of the Exchange Rate Mechanism (ERM) in 1993 for developed countries • Incidence of devaluations: the SS were associated with devaluations in 67 percent of emerging countries but only in 17 percent of developed countries • Real interest rates: there were sharp increases in real interest rates around SS, 4670 basis points for emerging countries and 3900 for developed countries • Reserves: the average reserve loss from peak to trough of the SS was 35.7 percent of the total • Current account: the average increase in the current account balance from trough to peak was 6.1 percent for emerging countries and 1.1 percent for developed countries There are two key determinants of SS revealed by the econometric analysis: openness as measured by the supply of tradable goods relative to absorption of tradable goods and DLD (Calvo et al. (2004)). Domestic policies determine the vulnerability to SS. Trade restrictive policies limit the supply of tradable goods. Unsound fiscal and monetary policies increase DLD. The results suggest that preventive policies should ensure the supply of tradables and prevent excessive DLD.

Currency Crashes 153

SS consist of a significant reduction in the short-term of the capital inflows of a country. CARs consist of major reductions in the CAD of a country in a short period of a year or two. The classification of episodes uses a definition of the SS as occurring in a country that received an inflow of capital relative to GDP above the region’s third quartile in the two preceding years, which then declined by at least 5 percent of GDP in one year. In the reversal, the CAD declines by 4 percent of GDP in one year (Edwards (2004)). The sample of Edwards of multiple countries over 30 years shows a historical incidence of SS of 6.4 percent, with the highest incidence in the Middle East (11.3 percent) and the lowest in the industrial countries (3.7 percent). The overall incidence of reversals has been high, 12.8 percent, with the highest in Latin America and the Middle East, 16 percent, and the lowest in the industrial countries, 2.4 percent. In the total sample of 3106 observations, 46.8 percent of countries that experienced an SS also had a CAR and 22.8 percent of countries suffering a reversal also experienced an SS. The entire sample shows that there is no statistical significance of the difference in incidence of SS in countries with different degrees of capital mobility. However, the country groups do show some significant differences. For the entire sample, the incidence of CAD reversals is significantly lower for countries with high capital mobility but the regional results differ. Non-parametric tests by Edwards show that there has not been a significant relation between CAD reversals and banking crises and between SS and banking crises. Another contribution of Edwards is on the impact of SS and CARs on growth of GDP per capita and possible differences because of the degree of capital mobility. Using a more sophisticated econometric technique, Edwards finds that CARs have a negative impact on growth rates, reducing the short-term growth rate by 2 percent on average. SS had a negative impact on growth rates of 1.23–1.25 percent, much less than CARs. There does not appear to be evidence that capital mobility increases the incidence of crises. However, once the crisis starts, countries with higher capital mobility experienced a stronger adverse impact on growth. There is a theoretical difference in CADs depending on their origin (Adalet and Eichengreen (2005)). A CAD may be more benign if it originates in borrowings to invest in activities that increase productivity. In contrast, a CAD may be perverse if it originates in borrowing to finance government consumption or to maintain an overvaluation of the currency. There may also be differential impacts on growth

154 The Global Recession Risk

resulting from alternative policies of adjustment. An important issue of research is whether CARs are frequent and disruptive of growth. There was a higher incidence of CARs in 1972–97, 361 cases or 26 percent of the sample of Adalet and Eichengreen (2005), compared with only 11 percent of the sample in 1880–1914, 27 percent in 1918–39 and 12 percent in 1945–72. The size of the CARs, change in current account relative to GDP, was 5.5 percent in 1972–97 compared with 3.1 in 1880–1914, 6.4 in 1918–39 and 3.5 in 1945–72. Adalet and Eichengreen find a significant difference of 1.32 percentage points in growth before and after reversals in 1972–97, no significant difference in 1880–1941, 2.7 percentage points difference in 1918–39 and 3.8 percentage points in 1945–72. There is a V-shaped recovery as output jumps from a lower level. They find reversals more common in countries with high budget deficits and CADs, low GDPs (as proxy for weak institutions and markets) and in periods of high growth in the center country. The classical period from 1870 to World War I provides an interesting case of relatively free capital flows. However, these flows were not smooth. There were sharp reversals of international flows for all countries for which there is information (Catão (2005)). Reversals occurred in countries with various levels of per capita GDP, financial development and exchange rate regimes. Catão (2005) finds similarities with the experience since 1970, analyzed by Edwards (2004). In addition, there was “time-bunching” of reversals, as during recent SS, in the mid1870s, early 1890s and 1906–07, when there were financial crises and sovereign defaults. Catão (2005) identifies increases in discount rates in more developed countries as a joint event, suggesting that tightening monetary policy could have contributed to the SS. However, domestic fiscal imbalances and easy monetary policy constituted internal events that were also important in the SS. Financial depth, prudential regulation of monetary institutions and sound fiscal policy may have contributed to protect domestic economies and exchange rate stability. Catão derives a lesson from this history that immunity to currency crashes depends on monetary and fiscal prudence and the strength of the domestic banking sector.

The vulnerabilities of Mexico There are 19 elections in 18 months in Latin America. The outcomes are showing a move toward populist-nationalist regimes that confront the US and the IFIs in various forms. There are such regimes already,

Currency Crashes 155

with various degrees of ambivalence, in Venezuela, Argentina, Bolivia, Ecuador and Uruguay. There are left-of-center political administrations with moderate economic policies in Brazil and Chile. However, all these regimes combined do not add up to the importance for the international financial system posed by the election for president and the entire renewal of Congress in Mexico in July 2006. The IMF has usable resources of $150 billion, which are insufficient to cope with a crisis in several countries, especially if it affects Mexico. There may be need for meaningful financial engineering of the international financial architecture. The more likely event appeared to be a victory of Andrés Manuel López Obrador (AMLO) or of another candidate but without support in Congress, similar to the six years of Vicente Fox. At the end of the mandate of AMLO or one of the other candidates, Mexico would have been without decisions and reforms for 12 years. Government revenue is highly vulnerable to oil prices and there is no support for strengthening non-oil revenue, which is only about 10 percent of GDP, one of the lowest in the world. Moreover, the Mexican economy will stagnate without reforms that increase its productivity. The continuing lack of reforms in infrastructure, labor markets and productivity would deteriorate country risk, raising the costs of borrowing and discouraging foreign investment. The Mexican election authorities declared the victory of Felipe Calderon of Partido Acción Nacional (PAN) by a fraction of 1 percent. AMLO challenged the results in court and in the streets. NAFTA synchronized the economies of Mexico and the US. The IMF simulates an abrupt adjustment of the US CAD with a decline in US GDP growth to 0.5 percent per year during four years. Such a weak US economy could cause contraction and subsequent stagnation of the Mexican economy. There is an issue if stress tests could capture the impact of such conditions on Mexico’s external and internal balance. Mexico is not the only case of risk of an abrupt US adjustment but it illustrates what could happen in other emerging countries. The worst outcome would be another six years of failure to reform combined with an abrupt adjustment of the US. To be sure, there is no assurance of such an adverse set of circumstances. However, the risk of similar conditions suggests that Mexico and other countries should engage in reforms that reduce their vulnerabilities to international events out of their control. There is discussion below of these vulnerabilities to illustrate the links with adjustment of the imbalances in the US, Europe and Asia.

156 The Global Recession Risk

The Mexican Crisis 1994–95 constituted the first twin crisis of the balance of payments and the internal financial sector, motivating significant changes in International Financial Architecture (IFA) and major effort in analytical research.38 Mexico had various sources of vulnerability.39 The country virtually fixed the exchange rate. The CAD increased significantly relative to GDP, 8.37 percent in 1993, mostly because of large increases in credit instead of exchange rate overvaluation. In addition, interest rates in the United States rose sharply in 1994 in pursuit of inflation that did not materialize. Finally, Gil Díaz argues that there was a crisis trigger in the form of political tension throughout 1994. Mexico’s GDP declined by 6.2 percent in 1995 and that of Argentina by 2.8 percent. However, in 1996, Mexico’s GDP rose by 5.2 percent and that of Argentina by 4.2 percent. The crisis was deep but recovery was strong and rapid. Both countries experienced deep repercussions of the crisis on their banking systems. The analysis of balance sheet effects of an exchange crisis developed in part as analysis of internal reaction to the crises in Mexico, Argentina and subsequently of Asia. These effects had been present in the debt crisis of 1982 and in most business cycle episodes. The Mexican crisis shaped official thought and led to the G-10 or Rey Report, the departing document in IFA (Peláez and Peláez (2005, 77–9)). Mexico’s reserves were $6 billion and debt in dollar-indexed Tesobonos $28 billion. Criticism developed that the $40 billion international rescue package allowed investors in risky Mexican securities to exit “with no loss of value.” Possible moral hazard in an international safety net of countries rose as an argument in official financing during emerging country crises. Mexico turned around and made significant progress in economic policy and structural reform. The country experienced relatively high rates of growth of GDP—4.3 percent in 1998, 3.3 percent in 1999 and 6.2 percent in 2000—before the first recession in 2001 without domestic causes, with output stagnating. There was meager recovery in 2003, with growth of 1.9 percent, and sharp recovery in 2004 with growth of 4.4 percent. Meanwhile, inflation declined to 4.4 percent at the end of 2001, well below the target of 6.5 percent. Inflation is moving closer to the target of 3 percent. Currently, about 90 percent of Mexico’s exports are to the United States and 75 percent of imports originate from the US through NAFTA. Mexico is improving public debt management. While public sector external debt reached 50 percent of GDP in 1998, it declined to 41.2 percent in 2004. Table 5.1 shows indicators of the Mexican

Currency Crashes 157

economy. The government has repurchased Brady Bonds. Domestic sector public debt also shows improving profile. The CAD is settling at about 1 percent of GDP and the foreign debt at 23.5 percent. The Director of the Western Hemisphere Department of the IMF, Anoop Singh (2005), continues to view a favorable environment for the Latin America and the Caribbean (LAC) region. The IMF forecasts global GDP growth of 4.25 percent in 2005 and 2006. Relatively favorable fiscal and monetary policies still drive world growth. Thus, the IMF projects Latin America to grow above trend, at 4 percent in 2005 and 3.75 percent in 2006. There are favorable events in the LAC region. Structural adjustments in various countries reduced public debt/GDP ratios while current accounts are in surplus with growing net international reserves (NIR). Improved fiscal and monetary policies are permitting access to credit markets at favorable rates. Exchange rate flexibility and inflation control eliminated the past specter of overvalued exchange rates. However, Singh warns that there are downside risks. The key risk is a possible reduction of the rate of growth of major trading partners, accentuated by increasing oil prices and/or rising protectionism. There is also regional LAC vulnerability to tightening credit markets because of the high level of debt ratios in various countries. There are many

Table 5.1

Mexico, economic indicators 1998 1999

% year GDP CPI % GDP CAD Foreign Debt Public Debt Public Deficit $ Billion Reserves

2000

2001

2002 2003

2004

2005 2006

5 18.6

3.6 12.3

6.6 8.9

0 4.4

0.6 5.7

1.9 3.8

4.4 5.2

3 3.9

3.6 3.4

–3.8

–2.9

–3.2

–2.8

–2.1

–1.3

–1.1

–0.7

–0.8

39.4

36.9

28.3

26.1

25.2

25.9

23.5

50

46.6

42.2

41.7

43.6

44

41.2

–2.3

–2.2

–1.6

–1.3

–1.5

–1.6

0

–0.5

–1.1

31.8

31.8

35.5

44.8

50.6

59

64.1

71.3

77.4

Source: IMF, “IMF Concludes 2003 Article IV Consultation with Mexico,” PIN No. 03/130, Nov 6, 2003; “IMF Executive Board Concludes 2005 Article IV Consultation with Mexico,” PIN No. 05/160, Dec 1, 2005; World Economic Outlook April 2006.

158 The Global Recession Risk

required structural reforms in the LAC region: fiscal reform, more open trade and FDI, strengthening of the business environment and better use of natural resources. Singh (2005) summarizes a simulation of combined risks of an increase in protectionism, a disorderly adjustment of global imbalances and a flight out of dollar assets. Growth of GDP in the US would collapse to 0.5 percent for several years. The impact of a reduction of American demand by 4 percentage points, a sharp depreciation of the dollar and a rise in global interest rates would spread to other developed countries and to emerging countries. Historical experience shows that increases in US interest rates can cause widening of emerging market spreads. Commodity prices would decline, deteriorating the terms of trade of many LAC countries. Simulations of the IMF staff conclude that GDP growth in the LAC region would decline by 5 percentage points, with major deterioration of current account positions. Relatively high debt ratios could cause major internal fiscal adjustment. There have been some improvements in IFA (Peláez and Peláez (2005)). However, the IMF, with only $150 billion of usable resources, and the other international financial institutions cannot resolve multiple country crises. There is special concern because of 19 elections in 18 months in LAC, including those in major countries. Many of these elections do not suggest that there will be a mandate for structural reforms to strengthen their economies. There may be need of a meaningful exercise of IFA. The IMF Article IV Consultation for 2005, IMF (2005Oct19), finds major improvement in Mexican economic policy in the past ten years: reduction of the public debt below 50 percent of GDP as a result of fiscal policy, sound monetary policy, control of inflation, limited vulnerability to external shocks and access to foreign capital markets at moderate cost with EMBI+ spread below 175 basis points. However, Mexico has an incomplete adjustment in the form of required structural reforms. Fiscal policy must attain consolidation over the mediumterm. The economy requires structural reforms to consolidate fiscal affairs, reduce vulnerabilities and improve international competitiveness that could permit higher future growth. The major reforms are in energy and telecommunications, labor markets, judicial system, taxation, regulation and business environment. Mexico did not make progress in the six years of the Fox Presidency because of the failure to obtain approval in a divided Congress. The labor force of Mexico is 43 million but only 12.8 million find formal employment in the private sector. Thus, most of the population is employed in the “informal” sector.

Currency Crashes 159

The net public debt of Mexico was 41.2 percent of GDP in 2004. The IMF forecasts a debt/GDP ratio of 40.4 in 2005 and 38.9 in 2006. The current account balance recently stabilized as increasing oil prices and inbound household remittances compensated for the rising non-oil trade deficit. The CAD of Mexico has stabilized at around 1 percent of GDP since 2003. Mexico’s NIR climbed above $60 billion 1 in 2004 and constitute 4 2 months of imports and exceed short-term liabilities by 1.6 times. The average maturity of the internal debt of the federal government has increased from 1.5 years in 2000 to 2.6 years in 2004 and 3.1 years in mid-2005. Foreign exchange risk has significantly diminished with oil revenue of $30 billion exceeding interest payments on the foreign debt of $9 billion. Mexico does not need to tap foreign bond markets until 2007 because of its strong international liquidity. The IMF (2005Oct19) forecast is for growth of GDP in Mexico of 3 percent in 2005 and 3.5 percent in 2006. This forecast depends on continuing manufacturing recovery in the US. The IMF forecasts inflation slightly below 4 percent in 2005, declining to 3.5 percent in 2006 and 3 percent in 2007. The IMF projects the fiscal deficit of Mexico at 2.4 percent of GDP in 2005 and 1.4 percent in 2006. The overall deficit was 6.7 percent in 1998–99 and 3.7 percent in 2000. However, the Fund forecasts the non-oil deficit at 9.8 percent of GDP in 2005 and 2006, not much better than 10.2 percent in 1998. Windfall oil revenues amount to 1 percent of GDP in 2005, of which one-third was used for investments in oil. Mexico requires fiscal reform to attain medium-term fiscal strength that is independent of oil revenues resulting from oil price increases. Oil revenue accounts for about 40 percent of total government revenue. Non-oil taxes account for only 10 percent of GDP, about one-half lower than in most countries. A comparison of 2005 with 2002 by the IMF shows a reduction of the overall deficit by 1 1 percent of GDP but an increase of the non-oil deficit by 1 4 percent. Thus, Mexico’s government finance is vulnerable to a decline in oil prices. Mexico plans budgets conservatively to avoid unexpected deviations caused by oil price changes. There are proposals to plan budgets over years to avoid deviations caused by changes in oil prices. The government proposed a zero deficit over a multi-year period using a medium-term reference oil price. Mexico could design fiscal policy on the basis of oil reserves and required investments in the oil sector. It is regrettable that Congress did not act on the proposal of tax reform by the Treasury Secretary Gil Díaz.

160 The Global Recession Risk

The exposure of public sector gross debt to exchange rate risk is only 16.3 percent of the total and 10.6 percent to rollover risk while medium- and long-term debt is 14.5 percent. An important vulnerabil3 ity is that 17 4 percent of the public domestic debt is short-term or yields a floating rate. The Fund reminds that public sector financing requirements are high at 10 percent of GDP per year. There is vulnerability to oil prices in that a decline of oil prices by $10 per barrel reduces government revenue by 1 percent of GDP. The Fund recommended Mexico to continue extending the maturity of its debt to avoid financing amortizations with short-term debt in a rising rate environment. Mexico could experience difficulties during slowing US and world economic growth caused by a run out of dollar assets, causing increases in interest rates. There would be a double impact by a decline in demand for Mexican goods in the US as well as lower oil prices resulting from declining world output. The overall deficit could increase by several percentage points because of oil and interest rate effects. Mexico would require prompt and strong fiscal measures to prevent further deterioration of domestic conditions. The Fund applied its debt sustainability analysis to Mexico. The public sector debt would still remain in the 48–50 percent range if GDP growth remained at only 1.2 percent and real interest rates at 8 percent during four consecutive years. The depreciation of Mexico’s currency would not significantly affect its fiscal accounts. The major risk would be an increase in the liquidity financing of the public sector, which can be mitigated by extending the maturity of the debt. Mexico has a strong external position. The deterioration of the trade account or slowing growth would not significantly affect the country’s foreign debt. Even major depreciation of the peso/dollar exchange rate until 2010 would not result in an increase of the foreign debt over 30 percent of GDP. An important risk of Mexico is a decline in oil prices. The IMF estimates that if oil prices declined to $40 per barrel, equivalent to $30 per barrel for Mexican oil, the primary fiscal balance would worsen by 1 percent of GDP per year. However, the gross public debt would remain above 45 percent of GDP and financing requirements about 13 percent of GDP. The most adverse scenario would consist of an abrupt adjustment of the United States external accounts, result in stagnation, higher domestic interest rates, lower remittances from Mexicans abroad and declining oil prices. The fiscal deficit would widen, causing possible lack of confidence on Mexican assets unless the authorities took strong fiscal measures.

Currency Crashes 161

Mexico’s financial markets have significantly improved relative to the crisis of 1994. Institutional investors with substantial assets under management diversified the financial system. NPLs are at a low of 1 2 2 percent of total loans, one-half of the 5 percent in 2001. The coverage ratios of banks for NPLs are 200 percent. Stress testing of banks shows resilience to shocks. The IMF (2005Dec1) Executive Board observed broad-based expansion of economic activity in Mexico with growth of 4.4 percent in 2004. However, certain sector-related aspects, including a “soft-patch” of industrial growth in the US, slowed Mexico’s growth to 2.8 percent in the first quarter of 2005. Recent indicators suggest recovery in the third quarter. The 12-month rate of inflation peaked at 5.4 percent in November 2004 but has declined to 3.1 percent in the first half of 2005. The EMBI+ spread declined to less than 150 basis points toward the end of 2005 while the stock market increased by more than 75 percent in domestic currency. On October 28, 2005, Mexico’s NIRs reached $62.3 billion. While the Directors of the IMF commended Mexico’s policies, they expressed their disappointment over the low pace of structural reforms. Mexico requires these reforms to improve its productivity and external competitiveness in order to attain growth rates that are satisfactory relative to its stage of development. The Directors pointed to the need of reforms in energy, telecommunications, labor markets, the judicial system, taxation, regulation and business environment. Chiquiar and Ramos-Francia (2004) find that NAFTA created links of production between the manufacturing sectors of the US and Mexico. A synchronization of the business cycles of both countries emerged. However, other unskilled labor-abundant countries have aggressively entered global trade with higher competitiveness relative to Mexico in some industries. The adverse shift of Mexico’s manufacturing output relative to the US could weaken the business cycle synchronization of these two partners in NAFTA. Mexico could have gained in specializing somewhat more on higher value-added industries, which would have permitted a longer lasting advantage relative to countries in Asia. Asian countries have created their own regional production-sharing networks, affecting the competitiveness of North American production chains. As a result, the entire production complex of some industries, such as apparel, has shifted to Asia. The analysis of Mexico’s competitiveness by the IMF (2005Oct19) is discouraging. The volume of Mexico’s exports in 2004 was roughly equal to that in 1996–98. Mexico’s share in world export markets is

162 The Global Recession Risk

currently similar to the level it attained immediately after NAFTA a decade ago. Mexico and China compete in the US in products that account for three quarters of their respective exports. Data from the Bank of Mexico (BOM) show that Mexico is increasing its share of exports in an expanding market only in car parts and furniture. In other products, Mexico is losing share in a market that is increasing in the share of global trade or increasing its share in a market declining in share of global trade. The rate of GDP growth of Mexico has oscillated in various periods 1 (Faal (2005)). Mexico grew at an average annual rate of 6 2 percent in 1960–79 or 3.4 percent in per capita terms. However, the rate of 1 growth declined to 2 2 percent on average in 1980–2003 or 0.9 percent per capita, lower only in Latin America than 1 percent for Brazil. The rate of growth averaged 5 percent in 1996–2000, declining to 1 percent in 2001–3, after the recession in the United States, and rose to 4.4 percent in 2004. Faal (2005) finds that a decline in TFP explains the decline in output growth of Mexico since 1980. In 1960–79, TFP grew at the average annual rate of 2.1 percent while output grew at 6.5 percent. In 1980–2003, GDP growth declined to an average annual rate of 2.6 percent. Lower TFP growth explains two-thirds of the decline in output growth of 3.9 percentage points. Incomplete reforms may partly explain the loss of dynamism of the economy of Mexico. There was external liberalization with trade rising from 27 percent of GDP in 1980 to 65 percent in 2003. However, internal liberalization was much slower. Significant internal distortions persisted in domestic regulation, inflexible labor markets and government-controlled electricity and petroleum. Faal (2005) considers three future scenarios of growth of Mexico. In the baseline scenario, TFP grows at 0.3 percent per year resulting in GDP growth of 3.2 percent per year on average in 2005–9. In the high scenario, a growth rate of 4.5 percent would require growth of TFP of 1 1 4 percent. Such an improvement could result from the recent financial reforms combined with further structural reforms. The low scenario uses actual decline of TFP in 1980–2003 that results in average growth of only 2 percent per year.

Original sin and debt intolerance There have been two additional contributions to the international macroeconomics of emerging countries. OS is the inability of a country

Currency Crashes 163

to issue liabilities in its own currency. DI is the hardship found by an emerging country in running debt to GDP ratios that advanced countries manage without problems. Each of these approaches is discussed in turn, followed by historical information on macroeconomic management and inflation for a large emerging country, Brazil, which provides support for the theory of DI. However, there is no attempt to provide a conclusive test of the relative merits of these theories. The analysis of the role of balance sheet effects in propagating an external crisis into an internal financial disruption uses three approaches: currency mismatches, DI and OS. In addition, there is concern with the less than desirable volume and instability of capital flows from advanced to emerging countries. There has been work showing that the three mechanisms are distinct (Eichengreen, Haussmann and Panizza (2005)). OS is the inability of a country to borrow abroad in instruments denominated in its national currency. DI is the difficulty of an emerging country to run debt/GDP ratios of the level of advanced countries. Currency mismatch is the excess of liabilities denominated in foreign currency relative to assets in domestic currency in balance sheets of the government, business and individuals. All three approaches seek to explain the volatility of emerging markets economies as manifested in the difficulty in serving their foreign debts (Eichengreen, Haussmann and Panizza (2005)). The DI approach links current problems to historical institutional deficiencies that lead to weak policies. The OS school contends that the difficulty of emerging countries to denominate debts in their own currency originates in the structure of international portfolios and the functioning of international financial markets. In particular, OS derives from the concentration of international financial portfolios in a few currencies— the dollar, the yen, the euro, the pound and the Swiss franc—with little investor interest in other currencies. OS prevents a country from bridging to the future a temporary current account deficit with the issue of securities denominated in foreign currency. Currency mismatches attempt to explain the consequences of these problems. The profession is still far from defining precisely the hypotheses and establishing testable implications and causality. Work by Caballero (2000) and Caballero and Krishnamurthy (2004) identifies two important characteristics of emerging markets: weak links with the private international financial sector and underdevelopment of the domestic financial sector. Caballero distinguishes between international financial liquidity that borrowers in the emerging market can pledge in intermediation of loans and domestic financial liquidity

164 The Global Recession Risk

that borrowers can use as collateral in domestic loans. Because of fear of floating on mismatched balance sheets, once a sudden stop occurs, the monetary authority prevents adjustment via exchange rates with adjustment by increasing interest rates. That is, monetary policy during SS is procyclical. In addition, the government cannot fund in international markets and increases its funding in the domestic market, further magnifying the squeeze on domestic activity. During the SS, there is relatively little international financial liquidity. Domestic borrowers do not have “insurance,” that is, they do not have credit to bridge their projects to the future. There is a decrease in prices of nontradables used as collateral in local loans. There is further deepening of the domestic crisis. Moreover, adverse selection prevents the economy from recovering. Caballero proposes that central banks avoid defending currencies with higher interest rates during SS. Policy should begin during booms of foreign financing. The central bank should acquire abundant international financial liquidity with issue of bonds. Ideally, the exchange rate regime should be a flexible exchange rate with medium-term inflation targets on non-tradables and active management of reserves. During SS, the central bank would provide international financial liquidity, contributing to smoothing the impact of the crisis. In addition, policy would be counter cyclical, avoiding increases in domestic interest rates, which would require tolerance with the inflation target. Success of this policy in practice requires a credible and autonomous central bank. In the long-term, structural change would consist in deepening the financial sector. The argument of DI proposes that the debt to GDP ratios of emerging markets are not likely to rise to those of developed countries without some default event or at least unusual hardship (Reinhart et al. (2003)). For example, the debt/GDP ratios of 60 percent of the Maastricht Treaty that created the EMU are not sustainable in many emerging countries. Reinhart et al. (2003) argue that “history matters,” that is, the past record of a country in honoring its debt obligations and in managing macroeconomics determines its ability to maintain a sustainable debt ratio in the future. DI explains why many emerging countries defaulted frequently in the past two centuries and why a small number of countries repeatedly draw resources from the IMF. The data assembled by Reinhart et al. (2003, 7, 12) are quite revealing. There are some countries plagued by recurring debt hardship. In 1958–2001, there were periods of more than 40 percent inflation in 12 months in 47.2 percent of the time in Argentina, 59 percent in

Currency Crashes 165

Brazil, 17 percent in Mexico, 58 percent in Turkey and 12 percent in Venezuela. Those countries had many incidents of default in 1822–1999 and the percentage of years in default was high: 26 percent in Argentina, 26 percent in Brazil, 47 percent in Mexico, 17 percent in Turkey and 39 percent in Venezuela. In contrast, there was a group of emerging countries and another of advanced countries without default history. These countries defaulted with debt/GDP ratios that would have been manageable for advanced countries: 55 percent for Argentina in 1982 and 53.3 percent in 2001, 50 percent for Brazil in 1983, 47 percent for Mexico in 1982, 21 percent for Turkey in 1978 and for Venezuela 49 percent in 1982 and 44 percent in 1995. With the exception of Venezuela the debt to exports ratio before default was close to or higher than 300 percent. In 53 percent of the countries, the debt/GDP ratio was below 60 percent in the year prior to the credit event. Countries can be assigned to “clubs” or categories according to two measures, the Institutional Investors’ Ratings (IIR) and the debt/GNP ratio. Club A consists mostly of developed countries with an IIR (mean plus one standard deviation) above 67.7. Club C consists of countries with no access to credit with an IIR of 24.2 or less. The important theoretical interest is in the intermediate Club B, which consists mostly of emerging countries with IIRs higher than 24.2 but lower than 67.7. Reinhart et al. (2003) divide this club into four categories according to IIR range and debt/GNP ratios. History shows that movement to a higher club may take very long periods, requiring a major effort of improvement of a country’s creditworthiness. Empirical results show that a country’s current level of DI is explained by the long-term average of its debt/GDP ratio (Reinhart et al. (2003)). There are other explanatory variables such as debt/exports ratios, history of debt and past macroeconomic stability. The measure of creditworthiness, IIR, is the dependent variable in cross-country regressions. The past unfavorable record of repayment and inflation are important factors lowering the creditworthiness measured by IIR. The growth of the debt/GNP ratio has a negative and significant coefficient for all countries in clubs B and C. The approach of DI opens promising avenues of research. There is the empirical issue of documentation of the proposition that history of default, economic management and inflation matter in the determination of creditworthiness. In addition, history may reveal similarities in historical crises with those that occurred after the crisis in Mexico in 1994. The well-known research on financial history by Bordo and

166 The Global Recession Risk

Schwartz (1996, 1998, 2000), Bordo and Eichengreen (1999), Bordo and Murshid (2000) and Kindleberger and Aliber (2005), among others, has already provided useful analysis for many periods, regions and types of crises. The balance of this section considers evidence from the economic and financial history of Brazil. There is the troubling fact that Brazil’s debt spreads are among the five highest in nearly all periods, including those of sound exchange rate, fiscal and monetary policies. The economic history of Brazil does conform to the analysis of DI. There is a sample of the money stock of Brazil and its proximate determinants, yearly since 1809 and quarterly since 1852 (Peláez and Suzigan (1978, 1981); Peláez (1974, 1975, 1976a,b, 1979)). There are other independent measures of income and prices dating to 1861. The combined sample has more than 9000 observations. The analysis of this sample together with the historical records permits a view consistent with the proposition of DI but, of course, cannot show that DI is more powerful a theory than the approaches of OS and currency mismatches or even test any of the theories. The ordinary least squares (OLS) regressions of natural logarithms of two definitions of money (M1 and M2), income and prices on time are listed in Table 5.2 for the entire sample 1861–1970 and for 11 subperiods (Peláez (1979)). All equations show autocorrelation of residuals, the coefficients are highly significant and the R2s are quite high. The only objective of the statistics is to capture the rates of growth of the variables. The charting of the logarithms of the data shows nearly vertical curves toward the end of the sample. The data on money are comparatively more reliable because of the relatively small number of banks than the calculations of income and prices. For the period as a whole, M1 grew at the average compound rate of 9.3 percent per year, M2 at 6.2 percent, nominal income at 10.2 percent, and prices at 5.8 percent. There is no need to appeal to any theory to conclude that Brazil had uncommon fiscal mismanagement over the long-term, verified by budget data, which was accommodated by issue of money. Moreover, the rates of growth of money, nominal income and prices accelerated to high two-digit levels: 13.9 percent for the two definitions of money, 15.2 percent for nominal income and 10.3 percent for prices. That is, the fiscal mismanagement accelerated in the twentieth century. There was further acceleration during the period of import substitution industrialization after World War II. In 1945–1970, M1 grew at the average compound rate of 30.3 percent, M2 at 29.2 percent, nominal income at 33.2 percent and prices at 27.1 percent. There is similar com-

Currency Crashes 167

mentary below on the more relevant and recent period 1970–2005. What is truly surprising about this experience is that Brazil was able to maintain rapid rates of growth of real product and real product per capita. The data are more reliable for recent periods. However, average growth rates mask the alternation of booms and busts. The years 1808–61 were also characterized by fiscal mismanagement. The rate of growth of the money stock of Brazil in 1814–21 was an extremely high 21.1 percent (Peláez (1975)). The Portuguese King arrived in Brazil in 1808 as a fugitive of Napoleon. He provided “incentives” to domestic industry in an alleged following of Adam Smith and created the first Bank of Brazil. The King took with him the precious metals of the Bank of Brazil when he returned to Portugal in 1821, leaving the institution near bankruptcy. His son, Dom Pedro I, was the first emperor of Brazil. However, his fiscal policy was also lax as shown by an average growth rate of the money stock of 10 percent per year in 1822–29, while the cost of living rose at 12.9 percent and a measure of domestic inflation using English prices and the exchange rate at 8.5 percent. The money stock declined during the 1840s when Brazil began to export coffee; the quantity of exported coffee increased at the rate of 6.0 percent per year in the 1840s, suggesting a period of prosperity without inflationary pressure. There were numerous external crises in Brazil with deep internal financial and economic repercussions in 1857, 1864, 1875, 1889, 1906, 1920, 1924, 1929 and 1963 (Peláez and Suzigan (1981)). The panic of

Table 5.2

Brazil, average growth rates of money, income and prices

Period

M1

M2

Real Income

Per Capita

Prices

1861–1970 1861–1900 1861–1913 1861–1929 1900–1970 1900–1929 1900–1945 1920–1970 1920–1945 1920–1929 1929–1939 1945–1970

9.3 5.4 4.7 5.5 13.9 8.9 8.6 17.8 8.3 5.4 8.9 30.3

6.2 5.9 4.7 5.6 13.9 8.9 9.1 17.3 8.7 6.9 8.1 29.2

4.6 4.4 4.4 4.3 4.9 4.2 4.3 5.3 4.3 5.3 6.3 6.1

2.4 2.6 2.4 2.3 2.6 2.1 2.2 2.8 2.2 3.3 4.1 3.1

5.8 1.6 0.1 2.1 10.3 6.6 4.9 14.1 3.2 5.8 5.4 27.1

Sources: see Peláez (1979, 54).

168 The Global Recession Risk

1857 was a typical crash resulting from weak conditions in advanced countries that spread to the internal financial-economic system because of an inflexible exchange rate. Exchange and interest rates began to fluctuate in the beginning of the year but conditions sharply deteriorated after November 1, 1857, when a ship brought news of a contraction in the United States. On November 11, 1857, the Bank of Brazil paralyzed all transactions after continuing depreciation of the currency. The cash position of the Bank declined by 32 percent relative to the average of the three months before the crisis. There was a decline of currency in circulation by 18 percent. Initially, the Bank obtained support from the government and its banker, Rothschild & Sons, in London, to buy currency to support the parity of the exchange rate under the country’s law of the gold standard. It also used the reserves of gold to support the exchange rate. In February 1858, the weakening economic activities forced the abandoning of the exchange rate support policy to lower interest rates and prevent the spreading of the panic to economic activity. Another famous crisis is that around the beginning of the Republic in Brazil in 1889 (Peláez and Suzigan (1981), Triner and Wandschneider (2005), Fishlow (1972)).40 There were fundamental reforms, including a new corporate law. On January 17, 1890, Brazil authorized the establishment of banks of issue. The notes of these banks would be equivalent to legal tender. There was a mood of euphoria that Brazil would take off as a major economy. The capital of corporations established in Brazil increased by 377 percent between May 1888 and October 1890. As in past episodes, the euphoria was quickly followed by high inflation and a currency crash. There are doubts if the real rates of growth of Brazil were relatively high and if there was weakness in tropical trade that retarded the country. New research focuses on the causes of the economic retardation of Latin America (Haber (1997)). The impulse of growth of the coffee economy of Brazil was quite strong in the period of the free coffee economy 1857–1906 before the first market intervention by Brazil to support prices (Peláez (1976b)). In the period of the free coffee market of 1857–1906, two non-parametric tests accepted the null hypothesis of no trend and rejected the null hypothesis of no oscillation (Delfim Netto (1959)). Thus, coffee prices oscillated without trend. Physical exports of coffee increased at the high yearly average rate of 3.5 per cent (Peláez (1976b)). Brazil’s exchange receipts from coffee exporting in sterling increased at the average rate of 3.5 percent per year and receipts in domestic currency at 4.5 percent per year. Great

Currency Crashes 169

Britain supplied nearly all the imports of the coffee economy. In the period of the free coffee market, British export prices declined at the rate of 0.5 percent per year. Thus, the income terms of trade of the coffee economy improved at the relatively satisfactory average rate of 4.0 percent per year. This is only a lower bound of the rate of improvement of the terms of trade. While the quantity of coffee remained relatively constant, the quality of manufactured products improved significantly during the 50-year period considered. The tropical exporting economy of Brazil experienced an opportunity of absorbing rapidly increasing quantities of manufactures from the “workshop” countries. Therefore, the coffee trade constituted a golden opportunity for modernization in nineteenth-century Brazil. The recent experience of the economy of Brazil has not been different, except that the yearly growth rate of the economy declined from 6.2 percent in 1961–70 and 8.6 percent in 1971–80 to 1.6 percent in 1981–90 and 2.7 percent in 1991–2000. Table 5.3 shows the extremely high rates of inflation in Brazil in 1980–1994 with a peak of 2477 percent in 1993. The weakness in policy originated in a period of inward-directed development after the oil price increase of 1974. Brazil was highly dependent on imported oil during the 1970s. Although there were two oil-price shocks in 1973 and 1979, the growth rate of GDP was 7 percent per year on average (Goldfajn and Minella (2005)). The main policy of the authorities was to grow rapidly to absorb 1.5 million new entrants in the labor force every year. There was concern of social tensions if job creation did not meet the entry of younger people in the labor market. Brazil heavily subsidized investments by the private sector at low interest rates. In addition, it developed large projects in infrastructure through SOEs. The country followed an inward-directed policy, disregarding its competitiveness in international markets. There was a belief that a large internal market was sufficient to attain high growth rates to provide the required new jobs. Most nominal contracts were indexed. The authorities repressed indexing to permit cheaper financing of domestic industry and also believing that indexing lower than actual inflation would prevent the passing of current inflation to the future. Unfortunately, the crawling peg relative to the dollar followed a formula that repressed depreciation, increasing the gap in competitiveness in international trade. Brazil ran trade deficits of 1.6 percent of GDP. The current account deficit of Brazil was 4.7 percent of GDP on the average in 1974–80. The formula consisted of a trade-weighted

170 The Global Recession Risk Table 5.3

1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000

Brazil, CAD, GDP growth and CPI CAD $B

Δ %GDP

CPI

–12.8 –11.7 –16.3 –6.8 0 –0.2 –5.3 –1.4 4.2 1 –3.8 –1.4 6.1 –0.6 –1.7 –17.9 –23.1 –30.8 –33.7 –25.1 –24.7

9.2 –4.3 0.8 –2.9 5.4 7.8 7.5 3.5 –0.1 3.2 –4.3 1 –0.5 4.9 5.9 4.2 2.7 3.3 0.1 0.8 4.4

95.3 92.9 103.3 164.3 208.9 233.6 72.5 363.4 980.1 1972.9 1620.9 472.7 119.1 2477.1 916.4 22.4 9.6 5.2 1.7 8.9 5.9

Source: Banco Central do Brasil, INDECO.

index of inflation of major trading partners. The computation of this “purchasing power parity” rate camouflaged important changes in devaluations relative to the dollar. Suppose that an important market and competitor, such as Germany, devalued relative to the dollar, Brazil should have devalued to remain competitive in the internal market of Germany and relative to German products in other markets. However, the weighted average resulted in devaluation of the Brazilian currency relative to the German currency that caused the loss of exports to Germany and to other markets where Germany sold competing products. In addition, it was commonly argued that more aggressive devaluation would not increase exports of primary products, which have always had a significant but declining share in Brazil’s total exports. The policy of devaluation was consistent with the policy of repressing indexing and maintaining interest rates that encouraged investment and foreign indebtedness. The debt crisis of 1982 profoundly affected Brazil. The large CADs inherited from the earlier period, peaking at $16.3 billion in 1982, had

Currency Crashes 171

to be reversed in two years. There were two declines of real GDP, –4.3 percent in 1981 and –2.9 percent in 1983. However, the use of export policy provided the last high real growth rates of Brazil in 1984–86, with 7.8 percent in 1985 and 7.5 percent in 1986. Inflation remained at high levels and exploded in following years. Brazil was able to control inflation that declined to 22.4 percent in 1995 and then to 1.7 percent in 1998. However, the real exchange rate appreciated (Goldfajn and Minella (2005)). Brazil began to have large trade deficits. Initially, equity and debt investment financed the deficits. Interest rates and stock market returns were more attractive in Brazil than overseas. Part of the capital inflow consisted of temporary investment by Brazilians who held over $100 billion in offshore accounts. The current account balance changed from a surplus of 1.6 percent of GDP in 1992 to deficits above 4 percent after 1998. The fiscal deficit of Brazil in 1998 reached 10 percent of GDP. The stability of the currency and the high returns attracted temporary allocation of Brazilian holdings overseas disguised by various international investment vehicles. The world boom in FDI eventually began to finance Brazil’s external imbalance after 1997. Brazil had relatively loose fiscal policy after 1994. The PSBRs were very negative and high in 1995–99, ranging in 5.8–7.5 percent of GDP and averaging 6.5 percent of GDP (Giambiagi and Ronci (2004, 8)). The primary balance was positive at 5.2 percent of GDP in 1994 but deteriorated to 1.0 percent by 1997 and zero percent in 1998, turning positive above 3 percent of GDP after 1999. While average government revenue increased from 16.5 percent of GDP on average in 1991–94 to 22.6 percent in 1999–2002, non-financial government expenditure as percent of GDP also increased sharply from 12.4 to 16.7. The fiscal imbalance of Brazil caused a sharp increase in the total public debt from 30 percent of GDP in 1994 to 41.7 percent in 1998 to 55.5 percent in 2002. Brazilian authorities began to adjust public sector accounts after the external and internal crises in 1998–99 and again during the election in 2002. The threat of a moratorium was an important determinant of the change in attitudes, in particular because of the crisis in Argentina after 2001. Giambiagi and Ronci (2004) mention two criticisms of the adjustment: it was merely based on increases in revenue without reduction of expenditure and many of the measures were of a temporary nature such as the tax on financial transactions (or bank debit tax) and the impact on the oil authority Petrobras of increases in oil prices. There have been numerous criticisms of the tax on financial transactions and its distortion of economic activity.

172 The Global Recession Risk

This instrument taxes automatically all transactions throughout the production chain as they create a debit in bank accounts. It inhibits production and causes loss of competitiveness in trade. The fiscal imbalance coincided with external imbalance as shown in Table 5.4. Brazil had high trade deficits in 1997–98, of more than 6 percent of GDP, and huge dollar CADs, corresponding to more than 4 percent of GDP. Inflation remained relatively low for Brazilian standards but growth was mediocre with only three relatively good years in 1997–2005 with growth around 4 percent. Brazil repeated after 2002 part of the policy mix during the debt crisis of 1982–84. It combined strong exchange rate depreciation with growth of the world economy and global trade. The trade surplus of 2003 was $24.8 billion, or 3 percent of GDP, increasing in 2004 to $33.7 billion, or 5.6 percent of GDP. The current account surplus rose from 0.8 percent of GDP in 2003 to 1.9 percent in 2004 (Goldfajn and Minella (2005)). Brazil was able to increase its exports by 32 percent from 2003 to 2004, reaching the high level of $96.5 billion. The ratio of total trade, exports plus imports, reached 26.5 percent in 2004 in contrast with 14 percent on average in the 1990s. Goldfajn and Minella (2005) remind that there are various differences, including the facts that the recent adjustment of the trade account did not require contraction of imports, inflation has been lower and there has not been a contraction of GDP. However, in the adjustment after 1982, Brazil experienced high growth rates of GDP: –2.9 percent in 1983 but then 5.4 percent in 1984, 7.8 in 1985 and

Table 5.4 reserves

2005 2004 2003 2002 2001 2000 1999 1998 1997

Brazil, GDP growth, CPI, CAD, trade, debt, FDI, exchange rate and

GDP Δ%

CPI %

CAD % GDP

Foreign Debt $B

Trade $B

FDI $B

Real/USD

Reserves $B

2.3 4.9 –0.2 1.9 1.3 4.4 0.8 0.1 3.3

5.7 7.6 9.3 12.5 7.7 5.9 8.9 1.7 5.2

1.9 1.9 0.8 –1.7 –4.6 –4.0 –4.7 –4.3 –3.8

183 201 215 211 210 217 226 224 202

44.8 33.6 24.8 13.1 2.7 –0.7 –1.2 –6.6 –6.8

11.1 8.7 9.9 14.1 24.7 30.5 26.9 26.0 17.9

2.3 3.0 2.9 3.5 2.3 1.9 1.8 1.2 1.1

53.6 52.8 49.1 37.7 35.8 31.5 23.9 34.4

Source: Banco Central do Brasil, INDECO.

Currency Crashes 173

7.5 in 1986. In contrast, percent GDP growth has been weak recently: 0.1 in 1998, 0.8 in 1999, 4.4 in 2000, 1.3 in 2001, 1.9 in 2002, 0.5 in 2003 and 4.9 in 2004. The intensity of SS in Brazil was higher during domestic than in external crises (Goldfajn and Minella (2005)). The depreciation of the currency and expectation of regime change during the domestic crises motivated net capital outflows. During the Mexican and Asian crises, net flows were negative only during two quarters. There was rapid recovery in those episodes. However, during the exchange rate crisis in 1999 and the pre-election period in 2002, there were net outflows during three quarters. From the third quarter of 1998 to the first quarter of 1999, the capital account of Brazil had negative flows of $23.2 billion compared with positive flows of $48.1 billion in the prior four quarters. The flows in the first half of 2002 were –$12.7 billion in contrast with $13.1 billion in the prior year. There are several explanations for the difference in behavior (Goldfajn and Minella (2005)). There was an expectation of a change in the exchange rate regime in 1998–99. In fact, the initial depreciation was an overshooting of 77 percent. The exchange regime tolerated depreciation in 2002, which tended to arrest capital outflow and reverse expectations after significant depreciation. The more fixed regime in 1998–99 prevented significant depreciation. The standard departure for sustainability analysis is the simple accounting relation (Reinhart et al. (2003)): D(t + 1) = [1 + r(t)]D(t) – TB (t) where

(5.8)

D is total external debt, r the interest rate on the external debt, TB the trade balance and t time. Simple manipulation of 5.8 results in the expression of the steady state: TB/Y = (r – g)(D/Y) where

(5.9)

Y is output and g its rate of growth. However, analysis in practice supplements simulations of 5.9 with stress tests. Reinhart et al. (2003) remind that the approach of DI implies difficulties at certain debt thresholds for key emerging countries. The debt sustainability of Brazil and Mexico may cause comfort currently but total debt to GDP ratios show significant vulnerability during an international event of major proportions such as a flight out of dollar assets.

174 The Global Recession Risk

The balance sheet approach Devaluations in developing countries could have a high cost. A sample of 103 developing countries in the period 1971–2003 shows 188 currency crashes (Frankel (2005c)). The position of chief executive changed in 27 percent of those crashes within 12 months. In normal times, the chief executive changed 21 percent of the time in 12-month periods. Devaluation increases by 32 percent the probability of a chief executive losing the job. In normal times, the chief executive loses the job in six-month periods in 11.6 percent of the time but in 19.1 percent of the time after devaluation. The difference is statistically highly significant. The probability of the minister of finance or central bank governor losing the job increases by 63 percent and is highly significant. The phenomenon concentrates in middle-income countries, being low for poor countries and having no cases for rich countries. There are sets of policies that can diminish the impact on output of currency crashes (Frankel (2005c)). A country can face a sudden stop with an optimal combination of expenditure-reducing policies, such as tight monetary and fiscal policies, while using expenditure-switching policies to attain external balance. There are two policy variables, the exchange rate, or price of foreign exchange, and the domestic interest rate. In a linear model, two instruments—the exchange and interest rates—can attain two targets—external and internal balance. However, Frankel argues that the traditional textbook case has not worked out in practice. Attaining external balance has resulted in an internal contraction in the currency crashes after 1990 and there are no sets of policies that can bring both external and internal balance. Frankel finds significant appeal in the BSA to contractions of output in currency crashes of developing countries. The BSA focuses on stock variables contained in a country’s balance sheets. The origin of a crisis in this approach is a collapse of confidence on the ability of a country to service its foreign debt (Allen et al. (2002)). Internally, there are other important losses of confidence in the ability of: the government to service the internal debt, the banks to honor deposits and other liabilities and the repayment of loans and other liabilities by the non-financial private sector. The exit out of the local currency causes sharp depreciation of the exchange rate, recession and in many cases a CAR. The IMFC requested the incorporation of the BSA in country surveillance by the IMF. The Fund developed a framework for this purpose (IMF (2005Jul1)). The operational aspects are being incorporated in

Currency Crashes 175

Article IV Consultations and constitute an important source of information for the IFIs and for the individual countries. The objective of the BSA of the IMF is to construct an evaluation of the currency and maturity mismatches of the various sectors of the economy: public, financial private, non-financial private and the rest of the world. The operational tool of analysis is a matrix with the assets and liabilities of these various sectors. The total liabilities of the various sectors are classified in domestic and foreign currency for short-, medium- and long-term exposures. The public sector has the monetary base as a liability and the private sector has equity. The matrix permits the quantitative assessment of mismatches among sectors, revealing the vulnerabilities and the channels through which they provoke adverse effects. In a second stage, it is possible to conduct stress tests that would show alternative valuations of assets by sectors in accordance with shocks of variables. For example, an important test would consist of simulating the depreciation of the currency. However, the mismatches by themselves provide an indicator of the stress of the economy to depreciation. The study by the IMF staff found empirical support for various concerns of the executive directors (IMF (2004Jul1)): • Asset buffers: strong public balance sheets permit the use of asset buffers to break sudden disruptions, allowing time for successful policy action; an example is the creation of foreign exchange assets for the financial sector in Brazil in 1998–99 • Private balance sheets: buffers and hedges in private sector balance sheets promote risk allocation within and between sectors • Banking supervision: strong supervision can prevent balance sheet weakness in the form of currency exposures, in particular, of borrowers without foreign-currency earnings, and also risky maturity mismatches • Sound liability management: prudential management of balance sheets by the public and private sectors can contain key risks such as those originating in events of interest rates, currency values and rollover of positions The IMF (2005Jul1) presented an example of the behavior of balance sheet effects for a sample of 25 countries in 1992–2002. The results of this exercise are in Table 5.5. The objective was simply to illustrate the methods instead of an actual analysis of the movement of balance sheet risk, which would require more detailed research. The rise in the

176 The Global Recession Risk

total debt/GDP ratio to 60–70 percent has been an adverse development. Large countries such as Brazil and Mexico have much lower levels currently. DLD is high, comprising 40 percent in the form of deposits in foreign currency of the private financial sector. The rollover risk of 40 percent of bank assets to sovereign issuers is another weakness of the private financial sector. Brazil provided an important recent case of significant currency and maturity mismatches during the crisis of 1998–99. However, there was no contraction of the economy, making the case particularly interesting. The international events were the Russian default and the LTCM liquidation. An internal event was the presidential election of October 1998. The general approach of the authorities was to transfer exposures to currency risk from the balance sheet of the private sector to the government (IMF (2005Jul1)). The change in the exchange rate regime occurred after the mismatches were softened. There was an excellent environment in world markets in the 1990s to build the foreign debt by borrowings of the financial and corporate sectors. Brazil followed a crawling peg, creating the impression that there was limited currency risk.

Table 5.5

Changes in balance sheet vulnerabilities of 25 countries

Liabilities by sectors Risks

Public

Public debt

Debt/GDP 60–70% Increased Substantial

Domestic debt share Currency Rollover

Interest rate Assets by sectors Risks Primary surplus Debt/capital inflow Currency

Shorter-term debt and private holders High Public

Financial private

Non-financial private

40–45% deposits in foreign currency 40% of bank assets to sovereign

Domestic debt rose but high exposure

Financial private

Non-financial private

Net assets worsened Improved

Source: International Monetary Fund (2005Jul1).

Decrease in external assets

Currency Crashes 177

By the fourth quarter of 1998, the banking sector foreign debt reached $148 billion. The net financial assets (NFA) of the banking system were negative ($20 billion) in the beginning of 1997, excluding $15 billion in dollar-indexed debt. Because of the lower relative cost, assuming the continuing crawling peg, the corporate sector borrowed heavily in foreign currency. By late 1997, dollar-indexed government debt increased by $20 billion as the private sector mitigated its exposure. In 1998, the private sector absorbed an additional $23 billion in dollar-indexed debt. The authorities also reduced international reserves by $30 billion to avoid a currency collapse. The banking sector had hedged its position as well as some of the corporations in the private sector. In September–November 1998, the central bank increased the basic overnight rate from 19 to 40 percent. The banking sector shifted to holding assets indexed by the overnight rate, thus transferring the rate risk to the government. NPLs of the banking sector rose from 7.6 percent of total loans in 1997 to 10.2 percent in 1998 but then declined to 8.7 percent in 1999. The Brazilian currency depreciated by 30 percent in 1999 without a contraction of output. However, the public sector debt increased from 35 to 53 percent of GDP by the end of 1999. Brazil moved into the territory of suspicion of DI. Moreover, the structure of the debt deteriorated, with 90 percent in instruments indexed by the overnight rate or the exchange rate. There is a very strong case that balance sheet effects existed in crises before 1994 in countries with and without capital controls. The example of Brazil in 1985–87 in the appendix vividly shows the risks of balance sheet effects. DLD was present in most countries before 1994 and created difficulties in balance sheets similar to those in recent crises. DI is built through successive episodes of mismanagement of fiscal and monetary affairs. What appears to be a sound ratio of debt to GDP for an advanced country with no history of default may be a high vulnerability for a country with a troubled history over many years. The work of institutional building and information provided by the Bank for International Settlements, the IMF, the World Bank and many other international institutions is extremely important in strengthening the IFA. The strengthening of fiscal and monetary policy constitutes an indispensable ingredient in IFA. It cannot be dictated by the IFIs. However, there is a major role in advice. The executive and Congress in the individual countries are fully responsible for allowing vulnerabilities to emerge and explode.

178 The Global Recession Risk

There is an important aspect of the theory of DI that may be crucial in the current environment. The serial defaulting countries accumulated foreign debts during periods of relatively low international interest rates. The low yield of securities of advanced countries caused investment in high yield securities among which were the liabilities issued by emerging countries. Default occurred when international interest rates climbed to higher levels, causing a flight to quality. The recent period of low interest rates in advanced countries could be followed by higher interest rates with widening risk spreads. In that environment, countries afflicted by DI may experience difficulties as the prices of their liabilities collapse toward the point where default could be attractive once again. In a flight out of dollars, there could be an even more pronounced flight out of emerging market risk. To be sure, there is no theory and verification of DI. However, the possibility of a threshold of default by serial defaulting countries strongly suggests a key vulnerability that may threaten IFA.

Appendix: Balance sheets effects in practice The objective of this appendix is to show balance sheet effects during an emerging market event. These effects are illustrated with the impact of the wide swing of financial and economic variables in Brazil in 1985–87 during a monetary reform. A new administration of the ministry of finance from August 26, 1985 to April 29, 1987 followed an economic plan that caused substantial oscillation of financial variables (Peláez (1986, 1987)). The objective here is not to evaluate the economic plan but rather the adjustment of the portfolios of domestic financial institutions to the swing of variables. A new administration of the ministry of finance, from May 13, 1987 to December 21, 1987, implemented a second and similar economic plan. The Brazilian economic plan Plano Cruzado was in some ways similar to that of Argentina after June 14, 1985, Plano Austral (Peláez (1986)). Both plans changed the name of the currency, which gave the names to the plans. Brazilian financial institutions had a benefit of observing the earlier measures in Argentina. The monthly rate of inflation of Brazil had stabilized at around 10 percent per month in the first seven months of 1985. However, inflation rose to 15 percent in November, reaching 17.8 percent in January and 15 percent in February. In part, the authorities relaxed price controls to allow relative prices to reach some sort of “equilibrium” before launching the plan.

Currency Crashes 179

The authorities replaced the Brazilian currency, cruzeiro, with a new one, cruzado, by Decree-Law 2284 on March 10, 1986. The plan departed from the hypothesis that indexing sanctions inertial inflation, or downwardly rigid prices, preventing inflation control. Thus, the plan abolished indexing. Prices, wages and the exchange rate were frozen indefinitely. Inflation for March was allegedly manipulated to show deflation of 0.5 percent. The central bank moved interest rates downwardly from an annualized 400–500 percent per year (14–16 percent per month) in February, with annualized inflation of 382 percent, to 6 percent per year (0.5 percent per month) for savings deposits and 15 percent per year (1.2 percent per month) for CDs but with a withholding tax of 40 percent for the latter. This was a laboratory experiment for the working of balance sheet effects, showing their importance in currency crashes. During a few months, until June 1986, it appeared as if the plan would become the most successful economic strategy ever. The economy boomed as consumers increased their purchases of goods, by drawing on their savings accounts to benefit from prices controlled at artificially low levels. The rate of growth of the economy soared toward 8 percent and many companies were forced to use several shifts. However, all the common objections to price controls developed quickly. There were shortages of about everything. Black markets developed as consumers had to pay a price higher than that authorized legally in order to buy goods. There was generalized corruption by inspectors of price controls. Beef, which is basic in the consumption of Brazilians, disappeared or was available in the black market at a much higher price. Companies altered slightly products to market them at higher prices as “new” products or lowered the quality of existing ones as a form to circumvent the price controls. Final prices of many goods were lower than the sum of the cost of their component materials, capital and labor. Prices indexes did not capture the various forms of distortion of the price controls and official inflation underestimated actual inflation. Base money increased by 200 percent in six months, or 800 percent annualized, with interest rates trading below inflation for many months, maintaining the withdrawal of savings and the consumption boom. The exchange rate remained fixed with high domestic inflation, causing the loss of competitiveness of Brazilian exports. Foreign companies anticipated dividend remittances at the favorable overvalued exchange rate. Importers anticipated and over-invoiced imports and exporters lagged and under-invoiced exports. These practices in remittances and trade effectively constituted capital flight. In

180 The Global Recession Risk

short, there was significant repressed inflation and the cruzado became highly overvalued. However, the plan was extremely popular for many months. The only correct view proved to be increasing inflation, interest rates and devaluation. However, there were significant differential lags among investors in realizing the future path of financial variables. The understanding of asset and liability management decisions and trading strategies requires background on the various players in the market and the available financial instruments. These are considered in turn before showing the swing of interest rates and strategies to optimize portfolio returns. There were two types of banks in Brazil at the time. There were a few banks with huge network of branch offices throughout the country using the float as funding. The largest was the government-controlled Banco do Brasil with over 3000 branch offices. It had no reserve requirements and through its dual role as monetary authority and commercial bank could create its own cash. The largest non-government bank was Bradesco with more than 2000 branch offices, which rarely issued CDs. It significantly reduced its credit risk with limits on the amount any client could borrow. These banks created a huge network of branch offices to maximize the float of demand deposits, tax payments, company and personal debt collection and public utility payments. The implicit funding costs of the branch offices were investments in real estate and electronic systems to process operations and attract clients. Another cost was the labor force; Bradesco employed 150,000 people. The funding costs of this structure required an environment of high inflation and interest rates to remunerate the float. The decline of interest rates from two-digit monthly levels to 15 percent per year threatened to bankrupt the float-maximizing banks. Market participants feared the nationalization of banks. Some of the larger and all the smaller banks were buying money to sell. They were also organized in conglomerates but with smaller number of branch offices and less dependence on float. Regulation slowed the growth of branch offices of foreign banks. Many of the medium-sized banks ran mismatched books but did not measure the funding gaps. Only a few banks engaged in deliberate mismatch positions. The financial instruments in Brazil were somewhat complex and provided a wide range of arbitrage opportunities that had to be analyzed in various bank books. These arbitrage activities would certainly have caused concern of the BCBS because of their high risk. There is risk in arbitrage strategies but also in not engaging in defensive strategies

Currency Crashes 181

during wide swings of financial variables. The key instruments were as follows. The government Obligation of the National Treasury (OTN) was the key instrument because it was at the same time an indexed security and a currency. The OTN was primarily an indexed currency. The finance ministry specified the cruzado value of a unit of OTN on the first day of every month. Thus, the dimension of the OTN was cruzados per unit. The finance ministry increased this cruzado value per unit of the OTN every month by the consumer price index. Nominal contracts were indexed by the OTN by converting them into units of OTN. The cruzado value of the investment, loan, rent, salary, or whatever, was divided by the value of a unit of OTN, the result being units of OTN contracted. That is, cruzados divided by cruzados per unit equals the number of units of OTN. Thus, at initial settlement, the contract is defined in units of OTN instead of in cruzados. At maturity, the number of OTN contracted is multiplied by the value of the OTN of the date with pro rata adjustments to arrive at the cruzado value. If the authorities indexed the OTN by full inflation, the ratio of the OTN at maturity relative to the OTN at initial settlement is exactly equal to the inflation in the term of the contract. Both principal and interest were protected of inflation. The OTN was also a government bond. Two types of OTNs were issued in Brazil. The exchange OTNs could be redeemed at maturity by either their exchange or nominal value, whichever was highest. The exchange parity was defined at issue in the form of the dollar value of a unit of OTN, for each specific maturity. For example, the “4s of 88” or OTN maturing in May 1988 were set at maturity at $8.245 and the “11s of 1987” at $11.61. To obtain the cruzado value at redemption of a unit of OTN, the specific dollar value of a unit of OTN would simply be multiplied by the cruzado/dollar exchange rate at maturity. The dollar content was obtained by dividing the value of a unit of OTN by the average exchange rate in the business days of the month. Thus, the exchange yield of the bonds was devaluation and the nominal yield was indexing set in normal times equal to inflation. The term of the bonds was five years and the coupon 8 percent paid every six months, with a 35 percent withholding tax. Expectations of inflation and devaluation and their manipulation by the government determined whether the bonds traded at a yield to maturity at, below or above the coupon of issue. Resolution 1088 of the central bank specified limits on the leverage of positioning securities financed with sale and repurchase agreements (SRP). The central

182 The Global Recession Risk

bank also set daily the price of the bonds in SRP transactions under Resolution 550, increasing it daily by the SRP rate. The elements of yield of the OTN were discount or premium, devaluation or indexing and coupon. The cost was the rate on SRP. The pricing of a bond with an option of redemption by devaluation or indexing constituted a tough technical problem. The bank required a proprietary portfolio selection model to choose among the maturities those that provided optimum hedge of capital, which was critical to an American bank because of accounting of devaluation in its global operations. There had been two maxi devaluations of 30 percent in a day, in December 1979 and February 1983. The central bank bill (LBC) was a government security issued in weekly auctions, on Tuesdays, for terms of 182 and 273 days. At maturity the bill was redeemed at parity, which was equal to the cumulative SRP financing cost during its term. An extra yield was obtained from the discount of parity, which ranged in 0.2–1.0 percent, being typically about only 0.5 percent per year. The central bank intervened daily to ensure that the SRP financing cost of LBCs was uniform during the day to avoid losses in LBC positions. The LBCs were intended to reward SRP cost exactly. Approximately 65 percent of positions in LBC were held by commercial banks. The float-maximizing banks remunerated their investors in LBC at a rate lower than that of large transactions among financial institutions, which was equal to the bond’s yield. The CD was the major funding instrument of banks buying money to sell. The minimum legal term of CDs varied capriciously from 60 to 180 days; it was set at 60 days during the period analyzed here. CDs could be issued at a fixed rate quoted annually according to compound interest. The most common type was a flexible rate CD indexed by the OTN plus a coupon paid at maturity also quoted as an annual percentage according to compound interest. Regulations authorized banks to take deposits only from other financial institutions. However, other institutions could place money in banks. The rate was contracted on a day for clearing the following day. The instrument was denominated as certificate of inter-financial institution deposit (CDI). If a bank held a rising rate view, it could borrow period money through CDs and invest it in short-dated CDIs temporarily until the rates increased, allocating it then to period loans. If the rates were expected to decline, short-dated CDIs takings could fund the bank until the time when rates declined and period funds could be borrowed.

Currency Crashes 183

Nearly all government securities were carried in the money market of Brazil. Even OTNs used as hedge by American companies would be construed as carried because of the difficulty in determining whether they were financed by capital or loans. The legal form of carrying securities was by SRPs, which were tightly regulated by the central bank. For example, Resolution 1088 authorized commercial banks to carry 30 times capital in federal securities financed with SRPs of financial or non-financial entities or individuals. In the uncertainty of high inflation, the overnight SRP agreement of federal securities constituted the basic interest rate. Commercial banks devised a foreign exchange swap (FX swap) to borrow at a fixed rate for 180 days. This instrument was critical in a funding strategy to arbitrage the swings in financial variables. The FX swap originated in pre-export credit. The exporter would sell forward dollars to its bank in Brazil for delivery in 180 days at the exchange rate of the initial settlement. The bank in Brazil would obtain a pre-export loan for 180 days from a foreign bank, say in New York, which generated spot dollars. The bank in Brazil would sell the dollars to the central bank in exchange for spot cruzados. The following day the bank in Brazil would deliver the spot cruzados to the Brazilian exporter in the form of a pre-export loan. At the maturity date, the exporter would deliver the documents to the bank in Brazil, which would remit them to the foreign bank. In turn, the foreign bank would collect from the importer and credit the overseas account of the bank in Brazil. The exporter would pay the bank in Brazil the loan plus interest. There would be an accounting credit of the cruzado-equivalent portion of the exports to the Brazilian exporter, which would complete the transaction cycle. Typically, exporters were cruzado rich and would not need the loan. In the FX swap, the bank in Brazil would borrow from the exporter the proceeds from the sale of dollars to the central bank at a fixed rate for 180 days. In the uncertainty dominating Brazil, this was one of the few sources of relatively long-term fixed-rate funding. It was critical in arbitrage of interest rates, indexing and devaluation. The position in OTNs of a commercial bank could be used ingeniously to create devaluation-adjusted assets and liabilities, the final instrument of interest here. Brazilian law prohibited contracts in currencies other than dollars, with few specific exceptions. Dollar deposits were prohibited except at the central bank under specific regulations. Dollar loans were authorized only in case of a matching dollar funding

184 The Global Recession Risk

from abroad. However, there was an accounting need for hedge by American corporations in Brazil; European and Asian corporations did not have such a constraint. Banks created the market for dollar assets and liabilities by local subsidiaries of multinational corporations. In the case of dollar deposits used by American corporations to hedge their capital, a contract was signed with the corporation in which the bank would sell OTNs spot to the client with an option to repurchase the same OTNs forward. The OTNs actually never left the bank so that a given position could be used to generate deposits several times the value of the position. A local currency deposit was created yielding devaluation plus a pre-arranged charge or coupon. In the case of loans, a contract was signed with a client in which the bank would buy spot OTNs from the client with an option to sell the same OTNs forward. Here again the OTNs never left the bank. The transaction was simultaneous so that the client need not have any position in OTNs. It simply created a cruzado loan paying devaluation plus a pre-arranged charge over devaluation. The swing of interest rates, inflation and devaluation is shown in Table 5.6. ADM is the cost of the sale and repurchase agreement on CDs, used in funding when the yield curve steepened. Fixed rates on loans climbed from 17 percent in March 1986 to a peak of 950 percent in June 1987. By September 1986 they stood at 43 percent. In September and October it was possible to obtain some term money, for 90 days at the most, via interbank takings. However, the rates were 50–55 percent. An explosion of the rates was not expected until the end of the year, resulting from the combination of sharply increasing seasonal demand for money in November and December together with the release of repressed inflation after the key election on November 15, 1986. The correct rate view in December 1986 was that inflation would return at a high two-digit monthly level and that fixed rates would climb to levels of perhaps 400 percent. Profits from rising interest rates and the maxi-devaluation were obtained by means of the following set of strategies: • Funding for six months at fixed rates through FX swaps, which resulted in liabilities higher than assets in the fixed-rate book • Creating assets higher than liabilities in the flexible rate book • Financing devaluation assets higher than devaluation liabilities with fixed rate funds and short-dated funds • Financing period loans with CD SRP funds obtained through a loophole in legal leverage limits

Currency Crashes 185

The funding through the FX swap became more difficult after the moratorium of February 1987 reduced the volumes and terms of foreign trade lines. It is instructive to outline the analysis of risks and returns of the mismatch strategies. There was a possible risk of losses resulting from another price freeze, causing a collapse of interest rates. In books and press interviews, the economic authorities of the time have revealed that a new price freeze was considered and even developed into a formal proposal. There was a mitigating factor in that scenario. In a new price freeze, fixed-rate contracts would have had to be purged of the inflation component, as it was the case at the beginning of the cruzado and austral plans in Brazil and Argentina (Peláez (1986)). Otherwise an industrial company would have had its prices frozen while its debt continued at a rate of 200 percent. It was not until June 1987 that a new minister of finance implemented another price freeze and then fixed rates in contracts were actually deflated. The bank with

Devaluation Day

40 40 61 333 342 744 1367 392 1028 1238 1348 1248 347 163 187 132 293

39 24 33 69 185 586 1129 302 926 1191 1248 1052 311 146 175 127 287

39 42 58 152 388 861 1504 316 987 1238 1260 878 331 146 175 127 287

0 1.8 0 0.2 0.4 0.8 1 0.6 8.5 0.9 1.1 10.6 0.4 0.2 0.3 0.3 0.5

0 24 0 61 182 581 1137 298 1088 1243 165 62 101 101 260

Annual

ADM

42 48 55 155 261 460 750 500 640 850 850 800 160 175 190 235 310

Inflation Month

LBC

43 49 56 170 285 500 820 530 660 900 950 900 200 190 210 255 340

Annual

Interbank Deposit

9/1/1986 3-Oct 3-Nov 1-Dec 5-Jan 2-Feb 10-Feb 5-Mar 30-Apr 25-May 10-Jun 12-Jun 23-Jun 23-Jul 24-Aug 23-Sep 23-Oct

CD Fixed

Date

Brazil, interest rates, devaluation and inflation 1986–87 Loans Fixed

Table 5.6

1.7 23 1.9 25 3.3 48 7.3 132 16.8 546 13.9 379 13.9 379 14.4 402 20.9 881 23.2 1124 26.1 1510 26.1 1510 3.1 43 3.1 43 6.4 110 5.7 94 9.2 187

Source: data archive of daily interest rates and announcements of inflation and devaluation by authorities.

186 The Global Recession Risk

fixed rate funding had high profits because the deflation of fixed-rate contracts resulted in rates that were lower than those prevailing after the freeze. The devaluation book generated by OTN “options” provided the most challenging and profitable opportunities. Table 5.7 show a summary of computerized measurement of risks and rewards of positions in this book. In actual practice, forecasts of devaluation and interbank deposits were used, without incorporating a hypothetical maxi-devaluation, to estimate the return from a long position, a short position and the opportunity cost of not funding through this book (short minus long). The table shows a specific case assuming that the analysis would have been made on March 30, 1987, one month away from the first “maxi” devaluation, under perfect foresight and the listed interbank deposit rates for the next 91 days. The program measured the net income from the positions on every calendar day. For simplicity, only selected dates are shown. On March 30, the typical asset yielded devaluation plus 8 percent and the typical liability cost devaluation plus 4 percent. Thus, the matched book would have yielded 4 percent per year. This was a meager result compared with what could be obtained by a long position. In the first line, after 30 calendar days, the revenue from a long position was 16.2 percent and the expense of an interbank deposit 16.8 percent, resulting in a loss of 0.6 percent or $6182 per $1 million of position. This loss appeared to be low given the expectation of a maxi. Computation of positions of dollar book

Net

Per $1 M

%

%

$

%

%

%

$

$

16.8 17.9 46.2 64.3 73.6

0.6 8.1 10.1 28.1 26.2

6182 81524 100659 81085 262511

16.8 17.9 46.2 64.3 73.6

15.8 25.7 55.3 90.9 98.1

0.8 –6.2 –5.9 –13.9 –12.3

8335 –61693 –58780 –139504 –123504

14518 –143218 –159440 –420562 –386015

Revenue Interbank

% 16.2 26.1 56.3 92.4 99.8

Per $1M

Expense Devaluation + 4%

ShortLong

Net

30 35 60 78 91

Short

Expense Interbank

Days Forward

Revenue Devaluation + 8%

Long

per $1 M

Table 5.7

Currency Crashes 187

The short position in 30 days had revenue from the interbank deposit of 16.8 percent and expense of devaluation plus 4 percent, 15.8 percent, resulting in a gain of 0.8 percent or $8358 per $1 million. It appeared attractive to fund through this book for income purposes but it would have been a disastrous strategy. After 35 days, Brazil maxi devalued the cruzado. The income from a long position was $81,524 per $1 million. The short position would have cost $61,693 per $1 million. In 91 days, there was a second maxi and a long position of $1 million yielded $262,511 while a short position would have lost $123,504 per $1 million. In retrospect, the data are perfectly known and the decision seems obvious. In day to day management, there was substantial noise in the information and moral suasion by the authorities that camouflaged sometimes the correct strategy. The new finance minister, as anticipated, devalued during the first week in office, a common strategy to blame the predecessor. There were other arbitrage opportunities that are somewhat complex to explain here.

6 The Restrictions of Policy of the United States

The objective of this chapter is to probe the specific policy implications of the contributions surveyed in earlier chapters, providing new insights and guidelines. The relation between the budget and current account deficits is essential to an analysis of policy. Thus, the first section below recapitulates specific theoretical and empirical results with emphasis on how fiscal consolidation could reduce the external imbalance of the United States. The second section considers the fundamentals of the US economy that would influence positions by foreigners in dollars. The soundness of these fundamentals is critically important to assess whether adjustment of the CAD will occur through a disorderly correction or a more benign process. The final section considers the practical limitations of US policy and provides some guidelines of sound policy.

The budget and current account deficits The national income accounts constitute the departing point for the relation between the fiscal and current account deficits. National savings is by definition equal to private savings plus the government balance, which is government revenue less government expenditure. The current account equals national savings less investment or: Current account = national savings less investment = private savings plus (government revenue less expenditure) less investment Thus, the current account is a dynamic process (Obstfeld and Rogoff (1996, 15–16)). An excess of savings over investment will flow into 188

The Restrictions of Policy of the United States 189

foreign asset accumulation and an inflow of foreign debt will finance an excess of investment over savings. In the case of a budget deficit, government expenditure will exceed government revenue, subtracting from private savings. The foreign savings in the form of a current account deficit will finance the fiscal deficit. There is the view of the twin deficits that budget deficits cause current account deficits. There is an educated point of departure for analysis. In his scholarly exegesis of the evolution from the MundellFleming model in the 1960s to the new open economy macroeconomics, Obstfeld (2001, 9–10) considers the path breaking application of new tools by Mundell in 1962 to the analysis of the effective policy mix. The targets of policy are external balance, or zero official settlements balance, and internal balance, or full employment. The objective was to avoid a simple trade-off between domestic unemployment and external balance. The model assumes that fiscal and monetary policies can both raise output. However, they have different effects on interest rates. A country with unemployment and an external deficit could adopt fiscal expansion to raise internal demand and reduce unemployment and tight monetary policy to raise interest rates and attract foreign financing. The success of attracting foreign financing requires international capital mobility. Thus, the combination of debtfinanced fiscal expansion and tight monetary policy would finance the CAD. The increase in interest rates resulting from the combination of fiscal expansion and tight money would appreciate the exchange rate. The form of financing the fiscal expansion—by taxes or debt— can change the results (Frenkel and Razin (1987)). The appreciation of the exchange rate would occur because the government has a higher propensity to consume non-traded relative to imported goods (Kim and Roubini (2004, 7)). More recent new open economy macro models also predict that budget deficits will deteriorate the current account and appreciate the exchange rate (Kim and Roubini (2004, 9–11)). Frankel (2005a) interprets the Mundell-Fleming model as predicting that under assumptions of international capital mobility a fiscal expansion would significantly deteriorate the current account. However, Frankel considers two offsetting factors. According to Ricardian equivalence (Obstfeld and Rogoff (1996, 144–5), an increase in the budget deficit would increase national savings in the future, preventing a reduction of investment or a deterioration of the current account deficit. In addition, Feldstein-Horioka (1980) observed that capital mobility could not be as perfect as assumed, such that, a decline in

190 The Global Recession Risk

national savings would reduce investment instead of foreign financing of the shortfall to maintain investment. Frankel uses these propositions to analyze and compare the twin deficits during the 1980s and after 2001. According to Frankel, savings declined during the 1980s and thus did not prevent the crowding out of investment and the CAD. He argues that more than one-half of the decline in national savings affected the deterioration of the trade balance and less than one-half crowded out investment. The predictions of the Mundell-Fleming model were confirmed by the experience of the 1980s together with the mechanism of increasing real interest rates, real appreciation of the dollar and net capital inflow. Frankel argues that the experience after 2001 mirrors that of the 1980s. There were tax cuts and expenditure increases that caused a budget deficit with the fall in national savings reflecting in deterioration of the CAD. An essential difference in Frankel’s argument is that the Mundell-Fleming model assumes tight monetary policy during the fiscal expansion, which occurred in the 1980s but not after 2001 because the FRB eased monetary policy. Naturally, the difference is the concern of two-digit inflation in the early 1980s compared with fear of deflation in 2001–3. Frankel believes that eventually long-term interest rates will sharply increase again because of expectations of future deficits augmented by population ageing and unfunded entitlements. The CBO (2004) explains the increase in the CAD of the United States since 1991 in terms of three factors: a higher rate of economic growth in the US than in other industrial countries, the higher demand for dollar assets in other countries and the fiscal deficit after 2001. After the recession of 1991, the US grew in the 1990s at a yearly average rate of 3.7 percent compared with 2.2 in Europe and 1.2 in Japan. Demand for imports in the US was stronger than demand for American exports in the slower growing industrial countries. In addition, the recession of 1991 had differences with that in 2001 that explain the continuing CAD: a stronger dollar in 1997–2001 than in 1990–91, weaker growth in 1990–91 than in 2001, a sharp decline in the savings rate in 2001 and Kuwait war reparations in 1991. There was strong demand for dollar assets in the second half of the 1990s that maintained a strong dollar and low interest rates in the US, preventing exchange rate depreciation effects on the trade account. According to the CBO, the decline in the savings rate from 19.5 percent of GDP in 1980 to 13.5 in 2003 was accentuated by the recent fiscal deficits, contributing to CAD deterioration.

The Restrictions of Policy of the United States 191

Friedman (1988) was critical of the fiscal expansion during the 1980s. After the end of the decade, he tried to derive lessons from that experience (Friedman (1992)). He measured the excess of expenditure over revenue during the Reagan administration at $1413 billion. The borrowing resulting from this deficit tripled the outstanding interestbearing debt, or almost doubled it in real terms. The federal deficit was 4.1 percent of GNP on average or 3.3 percent when calculated on a high-employment basis. Friedman (1992) draws six observations from that experience: • Tax revenues declined because of across-the-board reductions in personal income tax rates • The reduction of tax revenues did not curb government expenditures • Private saving did not increase because of larger government deficits • Larger government deficits did not generate larger savings (opposite to Ricardian equivalence) • Larger deficits were at least contemporaneous with higher interest rates • Private investment was lower after larger fiscal deficits (crowding out effect) • Larger deficits resulted in lower net foreign investment with the US becoming a net debtor Friedman (2000a) used the revised national accounts of the US and the experience during the 1990s to evaluate the conclusions of Friedman (1992). He argues that the full employment fiscal balance of the US moved from a deficit of about 3 percent of GDP to balance in 1999. The economy grew at 3.7 percent per year on average in 1993–99, disproving the view that fiscal deficits were required for full employment and growth. Friedman also finds confirmation of the view that deficits crowd out investment when the economy nears full employment while the elimination of deficits removed constraints on investment. Business fixed investment grew at 9.8 percent per year on average in 1993–99, which was well above the 3.7 percent growth of GDP. However, Friedman cautions about three puzzles: • Productivity: the crowding out argument postulated that fiscal imbalance restrained capital investments that raised productivity, which increased at high rates during the 1990s when the fiscal imbalance declined

192 The Global Recession Risk

• Ricardian equivalence: the continuing decline of the savings to GDP ratio in the 1990s when fiscal savings increased is consistent with the proposition of Ricardo and Barro • Role of interest rates: the financing of US business in the 1990s with flows of equity raises doubts about the interest rate effects on investment of fiscal and monetary policies Friedman (2000a, 16) also comments on the twin deficits: While the 1980s showed that the United States is a sufficiently open economy that under some circumstances a budget deficit can crowd out the foreign sector too, the 1990s has put firmly to rest any naive version of the ‘twin deficits’ view of the effects of government imbalances. Table 6.1 provides data for the analysis of the proposition by Friedman on the need to reconsider the naive view of the effects of government imbalances on the current account. It is useful to consider his division of the data into decades. There is a problem of dimensions throughout all the decades. The fiscal imbalances are not at all proportionate to the CAD. In this eyeball econometrics, the cumulative fiscal imbalances do not explain a major part of the cumulative CAD. Much the same is true in the first part of the 1990s when fiscal imbalances coexisted with reduced CAD. There is an important break in the second half of the 1990s when an acceleration of the CAD occurs while the US develops the elusive fiscal surplus. The sharp deterioration of the fiscal balance from surplus to deficit in 2000–04 resulted in worsening of the CAD by only 1.4 percentage points of GDP. It is difficult to believe that a structural econometric model with lags could unveil better results than these simple observations. Table 6.1 contains an important fact. The highest level of capacity utilization in more than two decades was 84 in 1988 and the economy was operating above 80 in manufacturing during the second half of the 1980s. Croke et al. (2005) find that output contraction occurred in CAD adjustment of industrial countries only during periods of overheated economic conditions. The US adjusted during a period of relatively high utilization of capacity and the economy is currently operating under 80. Gramlich (2004) argues that there are theoretical scenarios in which the budget deficit causes the trade deficits, others in which the trade deficit creates the budget deficit and yet others in which they develop

The Restrictions of Policy of the United States 193 Table 6.1

United States indicators

Year

NIIP

Deficit

Debt

CAD

Capacity

1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

7.2 7.3 3.4 2.3 2.3 1.1 0 0 –2.8 –4.3 –7.1 –2.2 –1.9 –4.1 –4.6 9.9 12.2 11.4 16.2 23.2 23.6 21.6 21.2 20.7

–2.6 –4.0 –6.0 –4.8 –5.1 –5.0 –3.2 –3.1 –2.8 –3.9 –4.5 –4.7 –3.9 –2.9 –2.2 –1.4 –0.3 0.8 1.4 2.5 1.3 –1.5 –3.4 –3.5 –2.6

25.8 28.7 33.0 34.0 36.3 39.5 40.6 40.9 40.6 42.0 45.3 48.1 49.4 49.3 49.2 48.5 46.0 44.0 41.0 36.0 33.0 33.0 35.0 37.0 37.0

0.2 –0.2 –1.1 –2.4 –2.8 –3.3 –3.4 –2.4 –1.8 –1.4 0.1 –0.8 –1.2 –1.7 –1.4 –1.5 –1.7 –2.5 –3.3 –4.3 –3.9 –4.5 –4.9 –5.7 –6.4

78 72 72 79 79 78 81 84 83 82 78 79 79 82 83 82 82 81 80 81 74 74 73 76 78

Note: capacity is in manufacturing; all other indicators are in percent of GDP. Source: the same as in Table 1.1; capacity from the FRB.

independently or even move in opposite directions as in the 1990s. The budget and the trade deficit can be linked but they are essentially different in their origin and consequences in the long-term. Gramlich derives the stability condition as: d(g – i)/(1 + g) = p

(6.1)

where d is the ratio of debt to GDP that does not increase the debt, g the rate of growth of nominal GDP, i the nominal interest rate and p the ratio of the primary deficit to GDP. The stability condition applies to both the budget and trade deficits. The primary deficit in budget accounts is that of the national income accounts, excluding interest payments. The primary trade deficit is the current account

194 The Global Recession Risk

deficit without net interest and dividend payments to foreigners. There are the following possibilities for the interest rate and the growth rate of the economy: Relation of i to g

Debt stability condition

i=g i>g i
Primary deficit must be zero Small primary surplus Small primary deficit

Because net income from the debt has been positive while the growth rate of the economy has been higher than the interest rate, the US could have stabilized the foreign debt while running a small trade deficit. Gramlich looks to the future with some concern about the budget deficits, which have not been particularly harmful in the US, with the budget deficit fluctuating in the range of 2–5 percent of GDP. The debt to GDP ratio may increase because of future increases in retirement and health costs. Fiscal policy will have to be tight to prevent unprecedented growth in the debt to GDP ratio. Gramlich warns that there is more concern about the future of the trade deficit and the external debt because the income elasticity of demand for imports by the US is higher than the foreign income elasticity of demand for US goods. He points to the self-equilibrating nature of the external deficit. There is a credibility range within which foreigners may be willing to hold increasing values of US assets. When this range is surpassed, there would be a combination of increasing interest rates to provide sufficient rewards to holders of US assets, increasing foreign prices, lower US prices or changes in exchange rates. The danger is whether adjustment would occur slowly without major consequences or abruptly. Feldstein (1992) argues that his empirical research shows that persistent changes in domestic savings cause parallel changes in domestic investment while in the short-term changes in international flows balance changes in domestic savings. He estimated that the decade average gross domestic investment rate for a sample of OECD countries had a gross domestic savings retention rate of 73 percent. That is, 73 percent of domestic savings in a country remain within that country. This estimate was consistent with estimates for earlier time periods and different sub samples of OECD countries. Japan had the highest decade average savings rate, 31.7 percent, while that of the US

The Restrictions of Policy of the United States 195

was 16.3 percent. The CAD of the US was 2.0 percent of GNP while the current account surplus of Japan was 2.2 percent of GNP. The joint imbalance of 4.2 percent of GNP was much lower than the difference in gross savings rates between the two countries, 15.4 percent. The highest saving rate of G7 countries was twice the lowest savings rate but no country had a share of foreign financing in investment in excess of 15 percent of the total and no country transferred more than 10 percent of its domestic savings abroad. Feldstein argues that the cross-section econometric relation that he estimated represents longterm equilibrium behavior. Capital inflows do not finance persistent budget deficits that simply “crowd out” domestic investment. Relations measured with instrumental variables confirm these savings findings. Feldstein mentions other examples of the lack of relation between budget deficits and CADs. The twin deficits hypothesis predicts that fiscal deficits crowd out investment by raising interest rates, causing an appreciation of the exchange rate that worsens the current account deficit. Fiscal consolidation would lower interest rates by diminishing the crowding out, depreciating the exchange rate and improving the current account. Kim and Roubini (2004) analyzed the US experience during the period of exchange rate flexibility. They concluded that the empirical evidence suggests a divergent path of the fiscal and current account balances, with cases of an improvement of the current account during worsening fiscal balances and vice versa. Their results suggest that a budget deficit could improve the current account and depreciate the real exchange rate, contradicting the predictions of theoretical models. There is a distinction between government expenditures on goods and services, which have a positive impact on domestic output and investment, and expenditures on hours worked, which have a negative impact (Cavallo (2005)). She confirms earlier research that an increase in government expenditure on goods and services of 1 percent of GDP deteriorates the current account by 0.5 percent of GDP. However, an increase of government expenditure on hours worked of 1 percent of GDP deteriorates the current account by only 0.05 percent of GDP. While the impact of an increase in government expenditure of goods is an increase in imports, deteriorating the current account, the increase of government expenditure in hours worked increases labor supply without much impact on the current account. The increase in expenditure on hours worked is non-traded and, thus, does not affect the excess of expenditure over national income, having no direct impact on the current account. It has a much lower indirect effect through its

196 The Global Recession Risk

increase of domestic private output and expenditure on consumption and investment. In fact, because of the high share of hours worked in total government expenditure, a fiscal deficit may even cause a minor improvement in the current account. According to Stockman (2005), the evidence does not support the claim of the twin deficits that budget deficits caused current account deficits. He contends that such claims focus on individual cases instead of on broad experience. In particular, the 1990s showed that fiscal surpluses coincide with current account deficits. Future government deficits will last longer because of entitlements and may have lower effects on the CAD. Adverse temporary income shocks cause more borrowing and consumption than permanent ones. Thus, temporary budget deficits may have stronger effects on the CAD than permanent ones. The explanation of the CAD is not declining savings rates in the US but rather an increase in savings rates in other countries, in particular, the developing economies, oil-producing countries and Germany. The US continued to provide the best alternative for investment of those savings. The unwinding of the CAD will occur through increasing exports by the US and partly by the decline in foreign-held US assets, or US liabilities, by the depreciation of the dollar. An important part of American policy will consist of institutional and structural change in the developing and oil-exporting countries that increase the relative attractiveness of investment at home. There is often a distinction of “benign” CADs in the 1990s because they coincided with fiscal surpluses and thus contributed to financing productive investment. “Perverse” CADs after 2001 coincided with fiscal deficits and thus foreign savings were used to finance government consumption and not productive investment. It is perhaps instructive to consider the policy concerns of a jobless recovery and double-dip recession in 2002 and the fear of deflation in 2003. There was active debate on the recovery of employment in the current upswing. Feldstein (2003b) argues that the rapid growth rate of productivity after 2001, at 4 percent per year, well above the average 2.6 percent in 1996–2000 and 1.5 percent in the prior 25 years, implied that firms could have increased output by 10 percent in 2001–03 without adding new labor. He argues that firms begin to add labor only after spending catches up with the increase in productivity. There is a longer than normal lag in employment generation in a recovery with high gains in productivity. Bernanke (2003b) observes that the recovery of employment after 2001 was even weaker than after the earlier recession of 1990–91,

The Restrictions of Policy of the United States 197

which was the first to earn the sobriquet “the jobless recovery.” He argues that productivity growth is an important explanation of the initially weaker labor markets in the current upswing. US business adapted to higher productivity growth, which permitted expanding output without new hiring. Frankel (2003) argues that the recovery by the time of his writing in late 2003 was characterized by weaker job creation than the monthly average of 240,000 new jobs in the earlier administration. Thus, job creation was insufficient for labor force growth and the job destruction during the recession. In addition, he also argues that the increase in productivity was more the result of cost cutting in business than actual technical progress in production. Moreover, economists were concerned about a double-dip recession.41 There may not be agreement on the need for fiscal and monetary stimulus, the types of policies (such as across-the-board tax cuts) and the actual effects on growth and employment. However, it appears that a complete evaluation of benign and perverse CADs must take into account the differences in the business cycle in the late 1990s and after 2001. The fiscal and monetary stimulus occurred because of concerns about a global slowdown or even recession with the possibility of deflation in major industrial countries such as Japan, the United States and Germany. Policy faced a trade-off between short-run recession and future fiscal consolidation. There is an additional issue of how worrisome is the external imbalance of the United States. Obstfeld (2005) is concerned with the relative size of the US CAD that equals 75 percent of the world’s surpluses, including those of China, Japan, Germany and other countries. He contends that there could be difficulty in finding an elusive soft landing for exchange rates. The foreign assets of the US are equivalent to 75 percent of GDP and the liabilities 100 percent. The risk and liquidity of assets and liabilities differ, as the US is short on debt instruments and long on equity instruments. Obstfeld and Rogoff estimate that CAD adjustment would cause the dollar to depreciate by 35 percent relative to the euro and by 35 percent relative to a basket of Asian currencies. The expectation of this depreciation of the dollar may at some point cause a change in portfolio allocation to dollar assets, causing a non-benign adjustment of the CAD. Obstfeld proposes fiscal adjustment to reduce foreign borrowing needs by the US. There are interesting comparisons with previous external and fiscal imbalances. Obstfeld and Rogoff (2005a–b) argue that the current US twin deficits occur during open-ended costs of security, ageing problems

198 The Global Recession Risk

of entitlements, increasing oil prices and excessive macroeconomic stimulus. Thus, they contend that the comparison of current conditions resembles more the years after 1972 than the late 1980s. A forced adjustment of the US CAD in a troubled world economy could result in financial crises, rising interest rates and a global contraction. Increasing taxes would be an important policy possibility, for which they find a parallel in the second Reagan Presidency. The increase in interest rates by the FRB could soften dollar depreciation and increase savings. Germany and Japan could increase productivity in their non-traded goods. Asia should adopt more flexible exchange rates. Obstfeld and Rogoff (2005b) argue that research on the adjustment of the current account in industrial countries considers mostly small open economies. The size of the US economy and its large share in world finance can be critical in determining the sustainability of its CAD. Research shows that the volume of trade of an economy and the size of its traded goods sector are important in determining the required exchange rate change. There was a 40 percent depreciation of the tradeweighted dollar during the adjustment of the CAD in the second half of the 1980s with relatively benign impact on employment and output. However, Obstfeld and Rogoff (2005b, 29–30) argue that the current adjustment of the CAD may resemble more the disruption that followed the end of the Bretton Woods system in the early 1970s. The United States had fiscal expansion and easy monetary policy in 1971–72, burdened by “open-ended” security costs. They argue that the combined effort of Iraq and homeland security could match the cumulative cost of the Vietnam War of 12 percent of GDP or 15 percent for the Korean War. Moreover, there are currently larger twin deficits as percent of GDP, less pronounced increases in energy costs and the breakdown of a fixed exchange rate system, Bretton Woods then and the Asian revived Bretton Woods now. Obstfeld and Rogoff express concern that the consequences of the adjustment of the CAD may be more severe in the current environment and more similar to the 1970s than relative to the benign adjustment of the second half of the 1980s. It is important to keep in mind that Obstfeld and Rogoff only mentioned this comparison briefly in the process of a major contribution to policy design based on a rigorous model. They intend to provide more analysis of the historical comparison in the future. However, the comparison is extremely interesting and revealing even if history seldom repeats itself. Forbes (2005) commends Obstfeld and Rogoff (2005) on the elegance and novelty of their powerful model for analysis and simulation of the US CAD. She also comments on the possibility of somewhat more

The Restrictions of Policy of the United States 199

benign unwinding of the deficit and the relevance of the comparison of the current CAD with earlier adjustments in the 1980s and 1970s. Forbes uses the shorthand formula for stability of the external debt: ng = c

(6.2)

where n is the ratio of the US external debt to nominal GNP, g the growth rate of the economy and c the percentage of the CAD to nominal GNP. If ng < c, the external debt of the US is increasing as a percentage of nominal GNP and if ng > c, the external debt is decreasing. Assuming growth of nominal GNP of 5 percent, 3 percent GNP growth and 2 percent inflation, and CAD of 2 percent of GNP, US external liabilities would stabilize at 50 percent of GNP. With CAD of 2 percent of GNP, net external liabilities would stabilize at 40 percent of GNP and with CAD of 3 percent, net external liabilities would stabilize at 60 percent of GNP. A ratio of 50 percent of external liabilities to GNP would be “manageable” for a country such as the US, that is, there would be no disorderly correction resulting from an exit out of dollar assets. Forbes identifies the peak CADs as percent of GDP as –0.7 percent in 1977, –3.4 percent in 1987 and –5.7 percent in 2004. There may still be a higher CAD as percent of GDP ahead. Forbes contends that the variables mentioned by Obstfeld and Rogoff are more similar between 2004 and 1987 than between 2004 and 1977. In fact, the only resemblance is in the increase of oil prices, 37 percent in 2004 and 62 percent in 1977 versus –25 percent in 1987. The fiscal imbalance was much higher in 2004 and 1987, –4.3 percent, compared with –2.2 percent in 1977. CPI inflation was also higher in 1977, 6.5 percent, compared with 3.6 percent in 1987 and 2.7 percent in 2004. “Open-ended” security costs, as measured by military spending, were higher in the cold war years of 1977, 4.7 percent of GDP, and 1987, 5.8 percent, than in 2004, 3.7 percent. Moreover, Forbes also found better adjustment circumstances in much higher trade as a share of GDP in 2004, 25.2 percent, and in the rate of growth of global GDP, 5.1 percent. The main point of Obstfeld and Rogoff is the historically high CAD and NIIP and the share of the CAD in world financial flows. Rogoff (2004) draws a parallel in the fiscal expansion of the early 1970s and after 2001. There were increases of social security benefits by 20 percent in 1972 and current fiscal expansion in drugs for the elderly, but more difficult to measure because current increases are in the future. There were military expenditures in Vietnam in the early

200 The Global Recession Risk

1970s and in Iraq and Afghanistan recently. The public deficit was 2 percent of GDP in 1972 and over 4 percent in 2004. The dollar depreciated in the early 1970s as well as after 2001. Rogoff argues that the depreciation of the early 1970s was initially stronger because rates were fixed under the Bretton Woods system but future depreciation to correct the present record CAD may be even stronger. Monetary policy was too liberal, threatening global price stability. The FRB eased monetary policy until 2004, lowering the fed funds rate to 1 percent. Rogoff argues that the recovery of the economy of the US could be linked to fiscal and monetary policy but warns about controlling the excesses after 2005. Some scholars prefer that there not be depreciation as a form of adjustment of the CAD. McKinnon (2004) observes that manufacturing output and employment declined from 27 and 24 percent of GDP, respectively, in the mid-1960s, to 13.8 and 10.5 percent in 2003. He contends that tax cuts without compensatory expense reductions decrease savings and increase the CAD in the US. The trade deficit in manufacturing is almost equal to the CAD. He obtains adjusted manufacturing output in the US by adding the CAD to actual output, which provides projected manufacturing employment under the assumption of no change in productivity. In 2003, employment in manufacturing would have been 13.9 percent of the labor force instead of the actual 10.5 percent, equivalent to a loss of 4.7 million jobs. McKinnon argues that the trend of decline of manufacturing began in the 1980s with the twin deficits. The fiscal consolidation of the 1990s was insufficient because of continuing weak savings. During the current administration, the fiscal deficit rose while household savings declined. His policy measure is fiscal consolidation to reverse the deficit into a surplus instead of exchange rate depreciation or protectionist measures. There may be some mitigating factors in the nature of the US assets and liabilities. Tille (2003) observes that the gross assets of the US declined from average annual changes of $864 billion in 1995–99 to –$262 billion in 1999–2001, constituting the most important factor in the annual jump of the NIIP from –$178 billion in 1995–99 to –$628 billion in 1999–2001. The gross assets and liabilities of the US may change because of financial flows or valuation changes. There are two valuation effects. First, the correlation between the market values of asset and liabilities determines changes in their relative valuation. Second, there are changes caused by the foreign-currency exposure of the gross assets and liabilities. Table 6.2 shows the effects of changes

The Restrictions of Policy of the United States 201 Table 6.2

Impact of the change of the dollar on the NIIP of the United States USD Appreciation

USD Depreciation

A. Effect on foreign currency denominated assets and liabilities

Lower USD value

Higher USD value

Example EUR 100

$90 at $0.90/EUR

$120 at $1.20/EUR

B. Effect on NIIP Foreign currency assets less than liabilities

Improve Decline in assets less than in liabilities

Deteriorate Increase in liabilities more than in assets

Foreign currency assets higher than liabilities

Deteriorate Decline in assets more than in liabilities

Improve Increase in assets more than in liabilities

in the dollar exchange rate on the NIIP. Part A is a simple numerical example. Consider a position of EUR100 taken at the rate USD1/EUR1. If the dollar appreciates to USD0.90/EUR1, the position is worth EUR100 (USD0.90/EUR1) equal to $90, that is, euro-denominated assets and liabilities decline in dollar value after an appreciation of the dollar. Euro-denominated assets and liabilities would increase in dollar value if the dollar depreciates. There is no change for assets and liabilities in dollar values, that is, the dollar value remains the same no matter what happens to the exchange rate. Part B of the table shows the impact of changes in the value of the dollar on the US NIIP. Consider the case that corresponds to reality in which the proportion of assets denominated in foreign currency is higher than foreign currency-denominated liabilities. The US issues most of its liabilities in its own currency, the dollar. If the dollar appreciates, the dollar value of assets will shrink more than that of liabilities, causing a deterioration in the dollar market value of the net liabilities of the US or NIIP. If the dollar depreciates, the dollar value of the assets of the US would increase relative to the dollar value of liabilities, causing an improvement in the dollar market value of the NIIP. The United States NIIP is valued in the currency of the country, the dollar. Consider a simple numerical example in which assets are EUR120 and liabilities EUR100 with initial rate of USD1/EUR1. After depreciation of the dollar to USD1.2/EUR1: [(EUR120 × USD1.2/EUR – EUR100 × USD1.2/EUR) – (EUR120 × USD1/EUR – (EUR100 × USD1/EUR)] = USD4 > 0

202 The Global Recession Risk

The accounting of the NIIP at market values requires the valuation of the gross assets and liabilities taking into account the market value of the positions and the capital gains or losses resulting from exchange rate changes. Tille (2003) shows that in 1990–2001, financial flows initially dominated the deterioration in the NIIP of the United States while in 1999–2001 the collapse of stock market indexes and the appreciation of the dollar significantly increased in relative importance. In 1999–2001, one-third of the deterioration of the NIIP originated in the appreciation of the dollar. The depreciation of the dollar would contribute to reverse the deterioration of the NIIP. Changes in the exchange rate of the dollar affect not only trade flows but also the market value of the NIIP.

The economic and financial fundamentals of the United States Investors in financial position in US assets make their decisions on relative evaluations of credit and market risks. There are credit risks of default and widening of credit spreads in individual positions such as, for example, in the acquisition of debt securities of General Motors and Ford relative to an issuer rated AAA. In addition, there are market risks such as deterioration in the prices of US debt securities as a result of tightening of monetary policy. Investors also evaluate exchange rate risks that may cause a loss when translating the investment to a different currency. There may be convertibility risk in the form of higher bid/ask spread in foreign exchange transactions, lack of sufficient foreign exchange for a remittance or even government restrictions on foreign remittances. Liquidity risks occur when positions may be too large to unwind without a costly decline in price. Concentration risk— of abnormally high exposure in an individual class of risk—has been present in all financial crises. Risk management consists of a set of tools to identify, measure, anticipate and control financial risks. The highest threat of the increasing and high US CAD and NIIP would occur in the form of a run for the exits out of dollar positions. Investors, both foreign and domestic, would evaluate adversely US risk, reducing the weight of US assets in favor of those in other currencies. The required rate of return for investment in US assets would increase sharply relative to alternative investments. This would be equivalent to an increase in interest rates. The reduction in dollar positions would deteriorate the exchange rate of the dollar, initially relative to other

The Restrictions of Policy of the United States 203

industrial countries such as Japan and those in the euro area, but subsequently relative to Asian currencies. The depreciation of the dollar could generate inflation in the US with resulting tightening by the FRB. The combination of increasing interest rates and exchange rate depreciation could disrupt financial markets and eventually the real sector of the economy. The rise in interest rates could cause declines in prices of financial assets and possibly of housing prices. There would be a test of the actual resilience of the US financial system to credit stress. It is difficult to conceive that there would not be an impact on the rest of the world because of the size of the US economy, which accounts for 21 percent of world GDP, and its role in driving world growth in the current environment. In short, the abrupt correction of the US external imbalance could result in a world recession. Croke et al. (2005) do not find evidence of such a correction of the CAD in the recent history of industrial countries. However, the fact that this type of phenomenon has not occurred does not preclude that it will not occur. The disorderly correction remains an event with unknown probability of occurrence. It must be examined carefully because of its potential for disruption. The CAD of the United States and the current account surpluses of Japan, Germany and China are the major world imbalances considered in policy discussions (Table 6.3). The CAD of the United States is 2–3 percentage points higher than the current account surpluses of Germany and Japan but at about the same ratio to GDP as the surplus of China. The US economy is much larger than those of the other countries. Thus, the imbalance of the US has a much higher global weight than those of other countries. The IMF adjusts actual budget balances for deviations of output from potential output and then measures the ratio relative to potential output. All countries whether with CAD or surplus have sizeable structural deficits. Japan has much higher fiscal deficits because of the decade-long fiscal and monetary stimulus to rescue the country from deflation. The US has the more comfortable debt to GDP ratio, below 50 percent, of all the countries with external imbalances. Japan has an extremely dangerous triple-digit internal debt. The US is growing and projected by the IMF to grow at annual rates exceeding by over 1 percent those of major industrial countries. In fact, the US has been the driver of global economic growth. A slowdown or contraction of the US economy could affect the entire world because there does not appear to be comparable dynamism in the euro area and Japan. China still has a modest weight in world output to replace the

204 The Global Recession Risk Table 6.3

External and internal balance, net debt and GDP growth 2004

2005

2006

2007

Current Account US Germany Euro Area Japan China

–5.7 3.7 0.8 3.8 3.6

–6.4 4.1 – 3.6 7.1

–6.5 3.6 0.2 3.2 6.9

–6.5 4.3 – 2.9 6.7

Structural Fiscal Balance US Germany Euro area Japan China

–4.4 –3.2 –2.2 –5.8 –1.5

–3.9 –2.6 –1.8 –5.4 –1.3

–4.0 –2.8 –1.7 –5.6 –1.1

–3.9 –1.6 –1.5 –5.5 –1.0

Net Debt US Germany Euro Area Japan

45.3 59.9 59.8 82.9

46.0 63.1 60.7 87.6

47.7 65.6 60.5 90.9

49.3 70.7 60.1 94.1

GDP Growth US Germany Euro area Japan China

4.2 1.6 2.1 2.3 10.1

3.5 0.9 1.3 2.7 9.9

3.4 1.3 2.0 2.8 9.5

3.3 1.0 1.9 2.1 9.0

All numbers are in percent of GDP except the structural balance in percent of potential GDP and GDP growth in percent per year. Source: World Economic Outlook, Sep 05; World Economic Outlook, Apr 06.

US as the driver of global growth. Moreover, China derives a significant impact of its growth impulse from the US economy. There are favorable and unfavorable investment fundamentals of the US. The favorable aspects are as follows: • Economic growth: the US has the most dynamic economy of the G7 with growth at potential output of more than 3 percent of GDP, much higher than the euro area and Japan • Projected growth: the IMF projects the US economy to grow at higher rates than those of the euro area and Japan • Growth of productivity: productivity growth in the US accelerated in the past ten years, surging ahead of the euro area and Japan

The Restrictions of Policy of the United States 205

• Protection of property and investor rights: the US has well-established institutions for claims on property and investor rights and a tradition of honoring those rights • Low political risk: the US has little if any political risk of extremes that could affect economic and financial performance • Strong financial sector: the financial and capital markets of the US are deep, efficient, diversified, transparent, capitalized and profitable with relatively moderate regulation and supervision • Price stability: inflation is not a problem currently in the US as in much of the rest of the world • Flexible product markets: the regulation of product markets in the US is relatively more moderate than in other countries, allowing for a much more dynamic entrepreneurial culture • Freedom of entry and exit: entrepreneurial efforts in the US are freer than in the euro area and Japan with greater freedom of entry and exit, even in the presence of oligopoly in markets • Flexible labor markets: the US labor markets are significantly more flexible than those in the euro area and Japan, permitting employment rates close to NAIRU This is an impressive list of attributes and many of them are key factors in explaining how the US has been able to attract such a large volume of financing from the rest of the world. Skoczylas and Tissot (2005) observe the stronger growth of productivity of the US relative to other industrial countries: The level of US labor productivity appears to be the highest among the major industrial countries and has been rising fastest in the recent past. But there is little doubt that the US performance has sharply improved in relative terms, as productivity growth has accelerated in the United States but decelerated in most other industrial economies. Indeed, only a few countries (mainly some Nordic countries) have also experienced a structural improvement in their productivity performance over recent years. In terms of growth rates, and according to the OECD, potential output might currently be 1 growing by around 3–3 4 % per year in the United States, compared 1 to around 2 2 % in the United Kingdom, 2% in the euro area and 1% in Japan. The US is growing at a rate similar to that in the 1980s while there has been sharp deceleration in the euro area and even more so in Japan.

206 The Global Recession Risk

There are also important risks of investing in the US. The Managing Director of the IMF warns that US growth constitutes one of the drivers of growth of the world but that its vulnerabilities are increasing (de Rato (2005)). He warns of the risk that at some point there could be a change in preference for US debt by foreigners that would lead to an abrupt increase in interest rates, which could cause a decline of prices of housing and other assets followed by a sharp reduction in demand by American households. The reduction of the budget deficit would be the best form of reducing the current account deficit. Fiscal consolidation is necessary anyway because of the future needs of entitlement programs. He believes that the US requires fiscal consolidation, a new Budget Enforcement Act and tax reform, including a broadening tax base. Action by the US alone would not be sufficient. Europe should adopt measures to increase flexibility in markets for labor, products and services, including the extension of the single market to services. This higher market flexibility would be part of a general growth strategy that would also cope with problems of unemployment and ageing. Asia requires exchange rate flexibility and structural reforms to motivate investment. There has not been a monopoly of policies to deteriorate the United States CAD. Fiscal and monetary policies have contributed, with different speeds, to the creation of the current policy dilemma. An important current restriction is tightening monetary policy. A recent episode of history is interesting and constitutes the sample for many of the stress tests used by governments and financial institutions (Peláez and Peláez (2005, 114–15)). The crash of bond markets in 1994 started in the United States after increases in short-term rates by the FRB, which resulted in an increase of around 150 basis points of the yield of the 30-year Treasury, shown in Table 6.4. Because of high duration, 30-year bond prices declined by approximately 13 percent per 100 basis points increase in yields. Leveraged positions with high duration suffered significantly. The 30-year fixed mortgage increased in yield by close to 200 basis points. Subsequently, bond prices of European countries also declined after large increases in 1993 caused by lags in their business cycles relative to the United States. European bond prices deteriorated throughout 1994 while many analysts and traders waited a decoupling with American bond prices that never occurred. Correlation in normal times of bond yields of the G3—United States, European Union and Japan—is only 0.18 and that of stock markets 0.40. Therefore, statistical models would not capture world scenarios of crash of fixed income securities and stocks in contrast with stress tests. Correlations suggest low risk, but global bonds

The Restrictions of Policy of the United States 207

declined in 1994, following American monetary tightening, which was an important factor of the Mexican Crisis. This episode is an important frame of reference. The Federal Open Market Committee (FOMC) is increasing fed fund rates uninterruptedly, toward a target above 4 percent and even more after the oil price increases. In the past, those levels of fed funds coincided with long-term yields of around 8 percent. Balls and Giles (2005) report that Greenspan continued to show optimism that the combination of flexible markets and budget restraint will adjust market imbalances. He believes that the market will permit stability of the CAD and over the long-term reduce financing requirements. Apparently, the FRB will not engage in manipulation of rates to encourage depreciation of the dollar, which may not work and is not part of the policy objective of the Fed. The rise in interest rates would complete the policy mix of the Mundell-Fleming model of fiscal stimulus and tight monetary policy, resulting in the twin deficits. However, the recent increase in interest rates has not had a major impact on bond prices as in the 1980s. There is the concern that increasing rates could affect mortgage rates and housing prices. Schnure (2005) observes that US housing prices have increased by 50 percent over the past five years. The US experienced boom-bust

Table 6.4

1994 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Fed funds rate, 30-year treasury, 30-year mortgage and CPI 30 Year T Bond

30 Year Mortgagee

Fed Funds Rate

CPI Past 12 months

6.29 6.49 6.91 7.27 7.41 7.40 7.58 7.49 7.71 7.94 8.08 7.87

7.07 7.15 7.68 8.32 8.60 8.40 8.61 8.51 8.64 8.93 9.17 9.20

3.00 3.25 3.50 3.75 4.25 4.25 4.25 4.75 4.75 4.75 5.50 6.00

2.52 2.51 2.51 2.36 2.29 2.49 2.77 2.69 2.96 2.61 2.67 2.67

Sources: www.federalreserve.gov www.http://data.bls.gov/cgi-bin/surveymost http://www.freddiemac.com/pmms/pmms30.htm

208 The Global Recession Risk

cycles in housing before the development of the current nationwide system of securitization. In the earlier system, there was balance-sheet lending. Securitization reduced risks. Schnure analyzes if the current system could experience a bust as in the past. There has been behavior in housing similar to the financing of bond positions by securities companies. Individuals have acquired housing financed with interestonly mortgages for periods of five years in the expectation of realizing a future capital gain. Most of these individuals do not have the experience and capital of investors in securities and housing does not have the liquidity and price transparency of government bonds. However, Schnure finds that housing price errors measured as deviations from prices explained by fundamentals have declined by one-half during the system of nationwide securitization. Moreover, the housing industry moved away from building supply ahead of demand to construction by orders. Thus, inventories are currently equivalent to four months of supply in the Northeast US and to three months in the West. In the past, housing prices stabilized at those levels of inventories instead of collapsing. It is instructive to view the housing market in terms of a class of credit models. Duffie and Singleton (2003) denominate an important class of credit models as structural models, following industry and academic convention. These structural models of credit risk relate the creditworthiness of a firm to its current assets and their evolution over time (Finger and Stamicar (2005)). The models calculate the probability of decline of the value of the assets below the liabilities, over a specified time period, using the level of assets, the volatility of assets and the level of liabilities. The value of the equity of the firm is the value of the assets less the liabilities. The models establish a relationship between the equity and credit markets where the path of the firm’s assets determines the firm’s equity and credit. Information in equity markets is more transparent and liquid allowing measurement and analysis of credit markets. There are two classes of successful structural industry models by Moody’s MKMV (Kealhofer and Bohn (2001)) and RiskMetrics (Finger (2002)). The departing premise of structural models is the seminal contribution by Fisher Black and Myron Scholes (1973) and Robert Merton (1974). Default at time T occurs when the value of the assets, A(T), is below the value of the firm’s debt, D, or A(T) ≤ D. The market value of the firm’s assets follows a log-normal diffusion process (Duffie and Singleton (2003)). Thus, the firm’s equity is a call option on the total assets, A, with strike value at the firm’s debt, D. The Black-Scholes

The Restrictions of Policy of the United States 209

formula can be used to obtain the value of the firm’s debt by deducting the option price from the initial asset value. The log-normal diffusion process of the asset value follows (Duffie and Singleton (2003)):

(

)

dAt = μ a − γ dt + σ adBt A

(6.3)

where μ a is the mean rate of return on assets, γ is the proportional cash payout rate, σ a is the asset volatility and B is a standard Brownian motion (see Billingsley (1995)). There are also first passage models in which default is triggered when assets cross a default barrier (Duffie and Singleton (2003)). The housing market is probably operating with relatively low historical levels of individual equity. There is an application of structural models to the individual decisions on whether or not to continue paying a mortgage. The costs of sale would include realtor and legal fees. There could be a point where the expected net sale value of the real estate may be just lower than the value of the mortgage. At that point, there would be an incentive to default. The default vulnerability of securitization is unknown. Another important cause of concern about the US is the high value of its foreign borrowing. Obstfeld and Rogoff (2005b) observe that the CAD of the US is about 75 percent of the world’s current account surpluses. Swiston (2005) introduces calculations showing that valuation changes in 2002 and 2003 improved the US NIIP by 7.2 percent of GDP, compensating a significant part of the deficit in financial flows of 10.4 percent of GDP. The expected correlation of the current account balance and the change in the NIIP, without valuation changes, is 1. However, valuation changes—originating in changes in the dollar exchange rate and the higher rate of return of external assets relative to liabilities—reduce the correlation in the sample of Swiston to 0.1. The share of holding assets in GDP in industrial countries more than doubled in 1990–2003. Swiston finds that the share of US assets in global portfolios is not significantly overweight relative to a calculation of the US benchmark share in those portfolios. US equities and FDI are underweight while debt securities are about market weight. Thus, he concludes that there may not be constraints in absorption of US claims in foreign portfolios. Swiston warns that the position in US net debt securities has declined to 25 percent of the market relative to only 13 percent in 1990. The average for industrial countries currently is 11 percent. The large size and continuing deterioration of the US NIIP

210 The Global Recession Risk

and the current account deficit combined with high holdings of US debt securities relative to market could pose problems of adjustment. The US has its own rigidities in the fiscal imbalance. One of the most important is the high cost of public expenditures on health. In 2002, the OECD median total expenditure on health care per person was $2220, in US PPP dollars of 2002, and that of the US $5267 (Ivaschenko (2005)). US expenditures for health care were 15 percent of GDP, twice the OECD average. The higher income per capita is an important explanatory variable of health care expenditures. Moreover, life expectancy tends to increase with the level of income per capita. Ivaschenko argues that other factors of the high expenditures on health care by the US are the decentralization of its system and nonuniversal insurance coverage. Reforms could probably reduce costs and improve efficiency. However, much the same as the euro zone and Japan, the US faces lack of political consensus on reforms. The Group of Ten (G10) (2005) prepared a report on the effects of ageing and pension system reform on financial markets and economic policies. The combination of decline in fertility rates and increase in life expectancy has accelerated the ageing of world population relative to earlier generations. Moreover, the baby boom generation is beginning to retire. The trend and effects of ageing are more worrisome in G10 countries, reflecting in the labor force in the form of higher dependency rates of retired workers and higher proportion of older workers, ages 55–64. The old age dependency ratio of the G10 will rise from 23 to 42 percent by 2050. There are extreme cases such as Italy and Japan with the dependency ratio jumping from 25 to 70 percent by 2050. The US dependency rate will increase from slightly about 15 to over 30 percent and most European countries will be above 40 percent. The dependency ratio of the non-G10 world will rise from 11 to about 25 percent by 2050. An important threat is the sharp rise of the G10 dependency ratio after 2010. The G10 report argues that ageing directly affects the supply of labor and indirectly its rate of utilization, investment, productivity, patterns of consumption, external balances and international capital flows. Brooks (2005) analyzes the impact of ageing on external balances. Analytically, countries with young dependency rates or old age dependency rates should have lower savings relative to investment, showing a tendency for current account deficits. The raising of children prevents savings; retirement involves some consumption of wealth. In contrast, countries with middle age working populations should have savings above investment, running current account surpluses and providing capital to countries with high young and old age dependency

The Restrictions of Policy of the United States 211

ratios. An IMF study of 115 countries in the period 1960 to 2000 confirms these propositions. The IMF projections show that the ageing of population in industrial countries will deteriorate the current account by 2.5 percent of GDP in Japan by 2050 and by 0.5 percent in Europe. However, the IMF predicts an improvement of the US current account balance by 1 percent of GDP by 2050. An IMF model that allows for greater interaction of variables predicts a deterioration of the current account of Europe and Japan by 8 percent of GDP by 2050 and an improvement of 6 percent for North America. The G10 report warns of significant fiscal effects of ageing. The projections of increases of expenditures on old age pensions as percent of GDP by 2050 are as follows: France 12.1 to 14.5, Germany 11.8 to 13.8, Italy 14.2 to 14.4, Japan 7.9 to 8.5 and US 4.4 to 6.2. The projection of increase of health and long-term care spending by the US is from 2.6 to 7 percent of GDP by 2050. There is increasing technical support for fiscal consolidation ahead of the ageing effects as well as for private sector firms to pre-fund entitlements. The IMF (2005Jun30) observes the departure of US financial flows from long-term trends toward unsustainable levels. US net internal liabilities are about 25 percent of GDP. The federal government budget deficit is 4.25 percent of GDP for calendar year 2004. The Fund estimates that the savings rate is 1.5–2 percentage points below the level consistent with household income and wealth. The staff of the IMF suggested that a permanent increase in the fiscal balance of 4 percentage points of GDP in the next five years would increase national savings by 3 percent of GDP and reduce the external deficit by 2 percent of GDP. The US current account would move toward a more sustainable level. Moreover, more aggressive fiscal consolidation by the US could strengthen its leadership within the G7 to encourage other countries to reduce global current account imbalances and related vulnerabilities. Fiscal consolidation could cause a downward trend of the debt to GDP ratio, reducing the burden to future generations resulting from population ageing. There would be ample time for reforms of social security and health. The staff of the Fund viewed favorably spending caps and pay-as-you-go (PAYGO), which require that proposals increasing the deficit be compensated by reductions in other budget items. However, the staff of the Fund recommended their extension to revenue. The IMF estimates that the actuarial liabilities of the Social Security system over the next 75 years are 30 percent of GDP compared with 200 percent for Medicare. The expenditures of the US on health care are higher as proportion of GDP than for any other member of the

212 The Global Recession Risk

OECD. Medicare and Medicaid constitute one-third of the total expenditures of the US on health care. The US is pursuing various measures to fully fund Social Security and diminish the burden of health care on public finance. Unfortunately, the analysis of relative fundamentals is not entirely conclusive. The weight of the fundamentals favors the US. However, relative fundamentals are not sufficiently strong to dismiss entirely the possibility of a disruptive adjustment of the CAD. There are no reliable measures of the probability and timing of occurrence of such a phenomenon.

The limitations of policy The administration has two instruments and three targets. The FRB cannot attain its two targets—price stability and full employment— with only one policy instrument—the fed funds rate, at least in a linear policy model. Treasury has limited control of only one instrument— the federal budget—because of required congressional approval. The third target is external balance, or a “sustainable” CAD. Two instruments cannot attain three targets. Budget policy is not effective in attaining external balance. The flexible dollar rate is the mechanism of current account balance by the private sector. Thus, there is a tendency for behavior by the private sector that will move the current account toward a sustainable level. The main issue is if public policy can reduce the costs of output and employment of the private sector adjustment. The approach followed by the Fed illustrates the limitations of policy. Monetary policy at the Fed under Greenspan (2004 Jan 3) combined two types of analyses. The environment of monetary policy is characterized by uncertainty, defined as lack of knowledge of the probability distribution, and risk, defined as events in a known probability distribution. The FRB has used a risk management approach to identify the sources of risk and uncertainty, quantifying them whenever possible and analyzing the costs of these risks. In addition, the FRB has accumulated knowledge over the years of the influence of a small set of variables on policy decisions and developed models to analyze their impact statistically. At the end, there is still a tough choice among many alternatives and a significant degree of imprecision. Greenspan (2004Jan3, 5) describes the technical limitations of policy: However, despite extensive efforts to capture and quantify what we perceive as the key macroeconomic relationships, our knowledge about many of the important linkages is far from complete and, in

The Restrictions of Policy of the United States 213

all likelihood, will always remain so. Every model, no matter how detailed or how well designed, conceptually and empirically, is a vastly simplified representation of the world that we experience with all its intricacies on a day-to-day basis. There are only two policy instruments, the fed funds rate and the fiscal budget. The Fed is independent and has a specific mandate on price stability and full employment, two targets and one instrument. The executive can propose a budget to Congress. There is a remote chance that Congress would approve a budget designed to curb internal demand in the United States in an international agreement in which Asian countries and Europe would increase their demand of American products. There is no reliable theory and measurement by economists that can provide with any accuracy the magnitude of demand reduction and the optimal instruments. A policy of curbing demand by medium-size doses to improve the CAD may well cause a recession that could spread to the rest of the world. The comments at the FOMC by John Balles, President of the Federal Reserve Bank of San Francisco, illustrate the difficulty of formulating policy with meager information:42 Mr. Balles…a 16 to 17 percent level for the 3-month Treasury bill for this year and next year, we would show that Treasury bill rate coming down to about 9 percent in ’82 and going down to about 7 percent in ’83. As I say, God only knows which model is right…but I wouldn’t. The BCBS of the Group of 10 has completed a new capital regulation framework with outstanding contributions by central bankers, practitioners and academics (Basel Committee (2004); Peláez and Peláez (2005, 242–82)). The BCBS concluded that there is not sufficient knowledge of credit risk management for a unified regulatory standard. Accordingly, Basel II has an advanced internal-ratings based approach in which banks use their own credit risk models when meeting minimum requirements. Evidently, managing banks is less complex than managing currencies and macroeconomic policies across the world. Thus, there is no theory or policy standard. Model errors are likely to abound. The Fund, Rajan (2004), has been consistently providing the following advice: • Fiscal consolidation and increase in savings in the United States • Structural reforms in the euro area and in Japan • Exchange rate flexibility and financial reform in emerging Asia

214 The Global Recession Risk

The success of this plan will depend critically on the credibility of reforms with investors. Adverse expectations of depreciation of the dollar may accentuate the depreciation. According to the analysis of Obstfeld-Rogoff (2005a–b), a short-term overshooting of the depreciation of the dollar could prove more costly in improving the CAD than slower depreciation. However, slow depreciation may not be feasible in reality, especially without structural reform in Europe and the Far East. Implementation of the IMF plan would require international cooperation to make it credible with investors. Credibility would buy the time required for changes in relative prices and productive structures. The G7 and the IMF have developed a concept of multilateral “shared responsibility” discussed in Introduction, Scope and Content. There are important lags in the policy process of shared responsibility required to attain global coordination to adjust imbalances. The appropriate approach to policy is stochastic (Friedman (1953)). The four lags of the policy process of global coordination are as follows: • The lag between the need of policy and recognition of the need: Obstfeld and Rogoff identified the need of policy five years ago, in 2000. Truman (2005) found peril already in the late 1990s. Mann (1999a–b, 2002, 2003) pioneered in the analysis of sustainability. However, the profession and the policy establishment reached consensus on the need only in the past 2–3 years • The lag between the recognition of the need and the diplomatic agreement on coordination: a global coordination of fiscal, monetary and exchange rate policies and structural reforms would require protracted negotiation before an agreement on an effective plan of coordination • The lag between the agreement on coordination and implementation: the diplomatic agreement would require full approval in various regions of the world on some of the most delicate issues of sovereignty, such as exchange rates, income policies, structural reform, etc. • The lag between full implementation and effects: slow pass-through of depreciation to prices illustrates one of the various lags in effect of policy impulses A recent change in policy illustrates the length of the lags. The US, the G7 and the IMF took three years of consultations with China to obtain an initial revaluation of 2 percent. The combined four lags above would absorb several years. If the disorderly correction has predictive value, the private sector will adjust abruptly and costly the CAD while discussions of policy continue at various levels.

The Restrictions of Policy of the United States 215

Policy guidelines Perhaps the best hope to adjust the United States fiscal imbalance without recession could be in the unknown factor that the economy may be in a lasting upswing. Table 6.5 shows the forecasts of the United States fiscal balance by the Congressional Budget Office. The fiscal deficit shows adjustment toward 2 percent of GDP. The CAD adjustment in industrial countries in the past 20 years occurred without disruptions and as part of the business cycle. Croke et al. (2005) found that the more adverse adjustments of the CAD in industrial countries occurred in overheated economies. Manufacturing capacity in the United States is about 80, which does not suggest that the economy is overheated. Naturally, there is no guarantee of such adjustment of the United States CAD. Persistent fiscal consolidation of the United States is a necessary effort because of other stability concerns and market allocation. The fiscal deficit was not the cause and is not the cure of the CAD. There is not much sensitivity of the CAD to the deficit or of savings to the deficit. Reduction of the deficit may be a difficult task in Congress. A failed worldwide Plaza Accord could cause the undesired disruption of exchange markets and the world economy. A concerted effort of structural reform in the euro area, Japan and emerging Asia could be more effective in ensuring a lasting transition to an improved international financial system. However, the elections in Germany do not provide much encouragement. The LDP in Japan has been in power for 50 years and Koizumi may have spent all the available reform capital. China is highly concerned about the collapse of agricultural prices caused by revaluation of the CNY because of

Table 6.5

United States fiscal balance

Year

Deficit $B

Deficit/GDP

2004 2005 2006 2007 2008 2009 2010 2011 2012

–412 –318 –337 –270 –259 –241 –222 –114 38

–3.6 –2.6 –2.6 –2.0 –1.8 –1.6 –1.4 0.7 0.2

Source: http://www.cbo.gov/budget/budproj.shtml

216 The Global Recession Risk

72,000 protests per year and 200 million underemployed people in rural areas. However, there is an important threat in Congress. Goldstein and Mussa (2005) emphasize the role of the IMF in surveillance of the exchange rate policies of its members, providing principles to guide them on appropriate policies. They contend the Fund has not been strong enough in promoting exchange rate appreciation in Asia to reduce global imbalances. According to Goldstein and Mussa, the CAD of the US would only decline to an acceptable 2–3 percent of GDP if there were a significant appreciation of Asian currencies, in particular, the CNY. They argue that persistent, massive intervention by Asian countries to prevent appreciation of their currencies is against the mandate of the IMF to provide guidance on exchange rate policies. The IMF should be stronger in promoting the appreciation of Asian currencies and should also seek a role by the G7 in discussion of exchange rate surveillance. Goldstein and Mussa warn that there is support in Congress for the Schumer-Graham bill that would impose tariffs on Chinese imports to compensate for the undervaluation of the CNY. The IMF should assume leadership to prevent a trade war. The conventional approach may work faster by changing inputs in simulations of policy models than in the realities of diplomacy of policy coordination. The lags of policy and actual effects should not prevent efforts to implement reforms and adjustments that have merits of their own. The broad macroeconomic guidelines of United States policy on external imbalance could include the following general principles: • Fiscal consolidation: continuing fiscal consolidation in the upswing of the business cycle because of its merits of avoiding the transfer of fiscal burdens to the future as well as improving resource allocation by the private sector • Gradual fiscal adjustment: no abrupt elimination of the entire fiscal imbalance because it would improve the CAD by less than 1 percentage point of GDP but could initiate a global income contraction • Global structural reform: continuing efforts within the G7 to convince Germany, Italy and France to reform their economies but with limited impact on the current account because the surplus is in Germany where politics prevent action • Product and labor market flexibility: reforms of regulations of product and labor markets to promote more even growth of productivity in major industrial countries with beneficial impact on future growth of potential GDP

The Restrictions of Policy of the United States 217

• Renminbi flexibility: continuing consultations with China, the G7 and the IMF to increase the flexibility of the CNY because it would improve the financial management of the Chinese economy • Appreciation of the yen: continuing consultations with Japan to permit the appreciation of the JPY after current elimination of deflation • G7 cooperation: efforts within the G7 and the international financial institutions, especially the IMF, to promote exchange rate flexibility and structural reforms in Asia, Europe and the developing countries • Macroeconomics of ageing: G7 countries must focus on the threat to macroeconomic stability of population ageing and on the need to pre-fund entitlements and reform perilous current structures Macroeconomic measures would not be sufficient to raise the competitiveness of the United States. Although the US has superior economic fundamentals, there are numerous reforms that would strengthen its relative position in the world economy (McCormack (2005c)).

Conclusion

The external imbalance of the US has very high dimensions. The US CAD is rising above 6–7 percent of GDP and its NIIP is moving toward a third of GDP. The US CAD is equivalent to 75 percent of the world CAD surpluses. Most simulations show a worsening of the CAD and NIIP. The concept of sustainability is theoretically elusive and empirically difficult to measure. The available theories and measurements suggest that the US CAD is in an unsustainable path. The more widespread concern is that at one point there will be an exit out of dollar assets. This reversal of capital flows would be mostly a market phenomenon. In anticipation of capital losses because of an expected devaluation of the dollar, investors would impose a premium on the interest rate of dollar-denominated assets. Eventually, there would not be high enough premiums required to attract sufficient international investment flows to finance the CAD. The US would experience a CAR with profound depreciation of the dollar. This depreciation would increase domestic inflation in the US. The expectation of inflation would raise interest rates. There is high exposure in US family balance sheets: high leverage in mortgages to finance real estate, low savings and rigid consumption habits. US imports are higher than exports by 56 percent. That is, exports must grow at a rate that is twice that of imports to stabilize the trade deficit. Thus, the reduction of the CAD from 7 to 3 percent of GDP would require a major increase in prices of tradables relative to nontraded goods to encourage resource transfer to production of tradable goods. Factor mobility is not instantaneous and frictionless in the real word. Thus, the process of adjustment would take several years. The IMF estimates that the adjustment would result in a reduction of the rate of GDP growth of the US to 0.5 percent per year during 218

Conclusion 219

several years. The world economy would lose its engine of growth. Recession could spread to all continents. As in all debates in economics, there are conflicting views. There are two currents of thought that dispute the need for adjustment. The revived Bretton Woods argument postulates that the peg of the Asian currencies to the dollar still has at least one more decade of existence without disruption. The undervaluation of Asian currencies, with resulting trade and current account surpluses, is a strategy of development, similar to that used by Japan and Europe in the earlier regime. Thus, Asian countries will continue to hold large dollar reserves to maintain their growth model, preventing a depreciation of the dollar. Another current of thought postulates that the US NIIP will increase toward 50 percent of GDP when there will be stability according to trend growth of GDP and inflation. There are other theoretical and empirical arguments questioning the seriousness of the US CAD. The United States borrows internationally on its own currency, the dollar, at extremely low interest rates, while it invests in assets denominated in foreign currency, receiving much higher equity premium. Thus, net income is positive and high for the US NIIP. Moreover, the depreciation of the dollar causes a favorable valuation effect in the form of a capital gain of net external assets. In fact, in some years, the valuation effect significantly reverses the increase in the US CAD. This argument, which is critical to understanding the issues, diminishes but does not eliminate the concern on the rising US CAD and NIIP. There is still the unanswered question as to whether there exists a set of magnitudes of financial variables where there would be an abrupt exit out of dollars, with possible non-benign adjustment of the US and the world economy. There are numerous explanations of how the US CAD increased to its current levels. An early view, the twin deficits hypothesis, argued that the budget deficit causes the CAD. In the Mundell-Fleming model, a budget deficit causes inflation, which raises interest rates, attracting foreign capital that creates the CAD. However, the empirical evidence shows CADs increasing during intended and actual budget surpluses and a wide variety of contradictory evidence. The ratio of the CAD to GDP was 4.2 percent in 2000 and developed during the fiscal surpluses of the 1990s. Thus, the twin deficit hypothesis could not explain the origin or even the major increase of the current CAD. There is another argument on whether the CADs were benign during the 1990s because they financed productive investment while they financed government consumption during the years of fiscal deficit. The dot com and real

220 The Global Recession Risk

estate investment are not likely what could be considered as investment in capacity that could generate production of tradable goods with which to reduce the CAD in the future. There have been other explanations of the US CAD, originating in the FRB. The US has a low and declining savings rate, which is the opposite in several Asian countries that have high savings rates. The development of a world savings glut would explain how the US CAD increased while international interest rates remained at their lowest levels in five decades. Although the US has external and internal deficits, Germany and Japan have current account surpluses with tough structural fiscal deficits. Moreover, the US has distanced itself from the rest of the world in the past ten years by a sustained increase in productivity. This increase in productivity has raised US potential output growth well above Japan and Europe. Fundamentals are relative evaluations and the US still has more attractiveness as a haven for investment than available alternatives. However, the size of the US CAD is a cause of concern even when accepting these explanations. There are no theoretical or empirical arguments refuting the possibility of an abrupt exit out of dollars, a proposition that is difficult to specify and test. There is an elegant conventional approach to the policy on global imbalances. The dollar must depreciate versus European currencies and also relative to Asian currencies. The US should reduce demand relative to output, as commonly argued, by fiscal consolidation. Europe, mostly Germany, and Japan should increase demand relative to output to diminish their trade surpluses. Asian currencies should revalue relative to the dollar. These policies would require substantial structural change in Europe and Asia. There are variants of this approach that propose close international coordination. If the theory of disorderly correction has predictive value, the conventional approach would not solve the problem in time. There are four important lags in implementing the proposal: between recognition of the need and beginning of coordination, between diplomatic efforts and an agreement, between the agreement and actual policy measures and, finally, between actual measures and their effects. There is still no consensus among policy makers on the recognition of the need of adjustment of their own countries. Thus, the policies of the conventional approach would have effects several years ahead while the models of sustainability suggest a disruption much sooner. In fact, the policy measures to change trends of demand relative to output require profound structural change in Germany and Japan, where there

Conclusion 221

is no political capital for drastic change. The implementation of the conventional approach would require measurements of actual doses of policy impulses. Economists cannot agree on a simpler problem such as credit models for Basel II. It may be more difficult to find an agreement on what amounts to developing a quantitative model to manage the entire world economy. There are disappointing issues on what US policy can effectively accomplish. The FRB has two objectives—full employment and stable prices—and one suspect instrument, the fed funds rate. External balance could only be considered indirectly because of its possible effects on full employment and prices. Treasury has another imperfectly controlled policy variable: the fiscal budget. It is difficult to conceive success in convincing Congress to reverse the fiscal deficit with the argument that it would prevent a disorderly correction originating in the trade deficit. There would be many more votes in favor of trade sanctions against China, which would be equally unsuccessful in reversing the trend of deterioration of the CAD. The policy kit, fed funds rate and the fiscal budget, does not have a sufficiently strong policy variable that would act quickly and decisively on the CAD. The lowering of interest rates under fear of deflation coincided with a fiscal deficit. The fiscal deficit did not cause the current account deficit. Fiscal consolidation will not eliminate the external imbalance of the US. However, the US has a greater threat in the long-term from running a high fiscal deficit than a CAD. This deficit not only redistributes resources away from productive activities into government consumption but causes a transfer to the future when retirement entitlements increase. There is need to engage in fiscal consolidation but it is likely to be postponed in case of economic weakness. The more powerful argument to enlist support of Congress is the adverse redistributive effect of fiscal deficits; the reduction of the CAD is more complex to explain and less likely to obtain required support. There has been insufficient focus on the credit issues in the current imbalances of the United States. The theory of the financial accelerator casts another cloud in the horizon. The overly leveraged balance sheets in the US, and in many other countries, could magnify a recession caused by an exit out of dollar assets. It is instructive to examine the analysis of the credit channel of monetary policy. There are credit market frictions in the actual world that do not exist in neoclassical models (Bernanke and Gertler (1999)). These frictions consist of problems of information, incentives and enforcement. Borrowers with strong financial positions obtain credit without

222 The Global Recession Risk

difficulties. The ability to borrow and lend depends on cash flows and the conditions of balance sheets. The transmission of effects of changes in asset prices to the economy occurs through balance sheets of households, firms and financial intermediaries. Access to credit may be impaired by the decline of asset values, such as real estate, that households use as collateral, causing an increase in leverage. Banks may experience constraints in lending when the value of holdings of assets decline because of the requirement to maintain certain levels of capital/asset ratios. Japanese banks provide a vivid recent example as equities and real estate depreciated in value, constraining bank lending for many years. Cash flows weaken as sales and employment decline with possible feedback to asset prices. There have been several explanations of debt deflation (Fisher (1933), Bernanke (1983)). The impact of asset prices will significantly depend on the initial state of balance sheets. Firms can use outside resources, such as issues of equity and debt, and internally generated resources, such as profits. Households can use outside resources, such as debt with or without collateral, and internal ones, such as savings. Because of the credit market frictions, outside finance without collateral is more expensive than internal finance. The premium on outside financing is inversely related to the quality of the balance sheets of borrowers. The higher is the equity of the borrower, the lower is the outside premium because the borrowing firm can provide more collateral to the lender. The fluctuations of output and investment are augmented by countercyclical movements in the premium for outside finance, which originate in the procyclical changes in the financial conditions of potential borrowers. Suppose there is a “primitive” shock in the economy such as technological change, which improves fundamentals with positive effects on output and employment. In the financial accelerator model, there are indirect effects originating in increases in asset prices, which improve balance sheets, lowering the outside finance premium. The lower premium causes further investment, which may lead to more indirect effects through improvements in balance sheets. Monetary easing can improve balance sheets by increasing asset prices, thus lowering the outside financing premium because of more abundant collateral. However, during monetary tightening in the presence of weak balance sheets, there are further adverse effects on net worth. Tightening causes a reduction in the value of collateral available for loans, squeezing households, firms and eventually financial intermediaries. The increase in the outside financing premium may result in

Conclusion 223

further decline of asset prices, further weakening the balance sheets. The effects would be different in direction of those of a benign primitive shock such as technological change. The financial accelerator is the magnification of initial shocks caused by endogenous changes in credit market conditions (Bernanke, Gertler and Gilchrist (1994)). The borrowers that have the highest costs of borrowing may experience the highest impact of an economic downturn. These borrowers have weak balance sheets and are typically consumers and small firms. There is a flight to quality by lenders, which limits the availability of credit to units with weak balance sheets. The borrower’s net worth is the sum of liquid assets and the collateral value of illiquid assets. The rise in interest rates causes a decline in the borrower’s net worth, increasing the premium for outside financing. The lower availability of outside financing at a higher premium results in a decline of investment and output. This process of magnification of the primary shock through secondary adverse balance sheet effects is the financial accelerator. The theory of the financial accelerator is related to information asymmetries between borrowers and lenders (Borio et al. (2000)). During economic booms, borrowers with weak fundamentals may obtain outside finance at reasonable premium because of the high value of collateral. However, during troubled economic conditions, even borrowers with sound projects may find difficulty in obtaining outside finance because of the depressed value of collateral. These sound projects would bring the economy out of recession. Borio et al. (2000) propose that lenders underestimate risks during booms and overestimate them during recessions. Thus, credit growth may be too high during expansions and very low during recessions, accentuating the adverse effects of the business cycle. The biased measurement of risk may excessively prolong booms and extend the severity and length of recessions. The risk of a recession is the difficulty of reversing economic conditions because of the failure of financial intermediation to finance sound projects that would restart the economy. Table C.1 shows the decline of mortgage rates in the US after the period of fear of deflation. The lowering costs of acquisition of residences caused a boom in real estate. The Conventional Mortgage Home Price Index (CMHPI) of Freddie Mac shows an increase of 55.2 percent from the third quarter of 2000 to the third quarter of 2005.43 The change in the CMHPI between the third quarter of 2004 and the third quarter of 2005 was 12.1 percent. In the five years ending

224 The Global Recession Risk Table C.1

2006–JUN 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 1986 1985 1984 1983 1982 1981

United States 30-year mortgage rate Rate

Points

6.68 6.27 5.75 5.88 6.05 7.07 7.38 7.91 6.74 7.10 7.60 7.20 9.20 7.17 8.21 8.50 9.67 9.74 10.61 10.64 9.32 11.20 13.18 13.42 13.62 16.95

0.5 0.5 0.6 0.7 0.6 0.8 1.0 1.0 1.0 1.8 1.7 1.8 1.8 1.7 1.6 1.8 1.9 2.0 2.1 2.1 2.1 2.3 2.5 2.2 2.2 2.1

http://www.freddiemac.com/pmms/pmms30.htm

in the fourth quarter of 2000, the CMHPI increased by 32.0 percent. Thus, in the ten years ending in 2005, the CMHPI increased by 104.9 percent. The US CPI increased by 31.5 percent in 1995–2005. Therefore, the CMHPI increased by 55.9 percent in real terms. The National Association of Realtors estimates that there have been equity gains in home ownership of $4 trillion since 2000. The price of the median house in the US increased from $169,500 in 2003 to $208,700 in 2005, or by 23.1 percent, while CPI inflation was 8.8 percent. The average house price increased in the same period from $215,000 to $258,700, or by 20.3 percent. Existing home sales increased from 6,183,000 in 2003 to 7,072,000 in 2005, or by 14.3 percent, while the inventory of houses stood at 5.1 months in December 2005.44

Conclusion 225

The low interest rate distorted even further individual balance sheets in the US. The characteristics of US balance sheets are: excessive leverage (such as in refinancing), concentration in real estate assets, no savings cushions and little extra available borrowing capacity. The theory of the credit channel (Bernanke and Gertler (1995)) postulates that there is a wedge between outside financing (such as debt and equity) and internal financing (such as savings and retained profits). There is an empirical result by Bernanke and Gertler (1995, 29) that the impact of a tightening of monetary policy is felt first and most strongly by residential real estate and consumer spending: We emphasize four basic facts about the response of the economy to monetary policy shocks: Fact 3: The earliest and sharpest declines in final demand occur in residential investment, with spending on consumer goods (including both durables and non-durables) close behind The increase in interest rates would deteriorate the wealth of Americans by raising debt payments in credit cards and by depreciating assets, in particular, real estate. The rise in rates would cause a decline in family wealth and in collateral, such as real estate, that could be used in more loans, preventing a bridge to the future with further borrowing. Moreover, the credit deterioration of financial assets would eventually affect the lending capacity of financial institutions. The rise in interest rates resulting from an exit out of dollars would magnify a recession through the impact on balance sheets. The US is the sole impulse of growth in the world economy. An American recession would spread to the rest of the world. An abrupt adjustment of the dollar and a US recession could have unfavorable impact not only on Europe and Japan but also on emerging countries in Asia and Latin America. The market for exports of those countries could be limited by weak economic conditions in the advanced countries. Emerging market spreads have declined to low levels. If there is DI in emerging markets, current debt ratios are high enough for a wave of defaults. There are equally weak balance sheets in emerging countries. The rise in interest rates would magnify the recession through the balance sheet effects. The usable resources of the IMF amount to only $150 billion and could not face simultaneous crises in several countries. There would be a critical test of IFA. It is instructive to consider the origin of the external imbalance of the US (Rajan (2006)). The crises of emerging countries and Japan in the

226 The Global Recession Risk

1990s released savings that were channeled to the US, which became attractive for investment because of its high productivity growth. In this first stage, the US capital account was the driver of its current account deficit. The US and other countries met the collapse of the IT stock market after 2000 with accommodative macropolicies that increased consumption and encouraged real estate investment. In the second stage, increased consumption to compensate for declining investment resulted in trade deficits and CADs. In the current third stage, strong worldwide growth, in particular in countries using commodities intensively such as the US and China, caused oil and commodity price increases that augmented the current account imbalances. The concern is that a US CAD of 6.5 percent of GDP that absorbs three quarters of world current account surpluses may not be sustainable. Rajan (2006) argues that “there is a limit to how much a country can depend on the outside world.” The surplus countries need policies to change their dependence on external demand while the deficit countries need to diminish their reliance on foreign savings. Because the adjustment seems to be inevitable and with high risks, Rajan proposes that it may be prudent to engage in a medium-term adjustment policy. An important advantage of such a policy is to reassure financial markets of concrete measures to prevent a disorderly adjustment. The IMF could play a role of impartially advising the policies that promote adjustment to engage multilateral cooperation. The IMF (2006May31) Article IV Consultation with the US found agreement with the FRB forecast of a favorable domestic macroeconomic environment in 2006–07. The mission concluded that there is risk of an abrupt unwinding of the external imbalance of the US, resulting in disorderly adjustment of exchange rates. The disruption of foreign exchange markets would have adverse effects on growth and employment. The IMF suggested the desirability of ensuring fiscal sustainability with stronger medium-term fiscal consolidation. Entitlement reform has not received sufficient political support. Fiscal consolidation and entitlement reform have merit on their own that is independent of a possible effect on reducing external imbalances via the savings/investment argument. The IMF mission reminded that spending on social security, Medicare and Medicaid account for more than two-fifths of federal spending and increase at what may be an unsustainable rate. Entitlement reforms and expenditure reduction may not be sufficient to compensate for the effects of population ageing. The IMF proposal is to engage in fiscal consolidation of 0.75 percent of GDP per year to balance the budget excluding the social security surplus over a five-year period. The result of this

Conclusion 227

consolidation would be a downward path of the federal debt-to-GDP ratio. Meanwhile, the US could engage in strong entitlement reforms. The IMF contends that national savings would increase, reducing the external imbalance. The data of the World Economic Outlook of the IMF sharply illustrate the dimensions of the global imbalances (Table C.2). The CAD of the US would be about $900 billion in 2007. It would absorb most of the world surpluses. The combined surplus of Japan and the other advanced countries would amount to only $285 billion. The emerging and developing markets would have a combined current account surplus of $473.2 billion. The policy coordination effort must focus on the emerging markets. The combined current account surplus of China and the fuel-exporting countries would amount to $613.4 billion, or 68 percent of the US CAD. The savings and investment data 2006–07 show the low savings rates of the US, 14–15 percent relative to the investment rates of 20.8–21.3 percent. The savings rates of the advanced countries, 19.8–20.2 percent, are not that different from the investment rates of 21.5–21.9 percent. The discrepancy is marked in the fuelexporting countries, savings rates of 36.1–32.7 percent relative to much lower investment rates of 21.9–22.6 percent. As Rajan argues, the global imbalances accumulated over various phases for different reasons. The worldwide increase of commodity prices, especially oil, aggravated the imbalances. An important vulnerability of the doctrine of shared responsibility is the more complex political process in the fuel-exporting countries, which may retard or prevent coordination of policies.

Table C.2

Global current account, trade balance, savings and investment Current Account $B

Region Advanced USA Euro area Japan Other Advanced Emerging Asia Middle East Fuel Exporting China

2006

2007

Trade Balance $B 2006

2007

–602.7 –615.7 –437.1 –396.5 –864.2 –899.4 –786.2 –771.3 –23.8 –1.4 125.9 154.1 140.2 133.6 44.8 33.2 145.1 151.4 201.6 217.1 486.7 473.2 486.7 473.2 159.5 171.9 159.5 171.9 240.9 235.6 240.9 235.6 423.7 423.8 423.7 423.8 173.3 189.6 173.3 189.6

Saving % GDP

Investment % GDP

2006 2007 2006 2007 19.8 14.4 21.5 26.9

20.2 15 22 26.8

21.5 20.8 21.5 24

21.9 21.3 21.9 23.9

31 39.9 38.7 36.1

30.8 40.4 34.3 32.7

27.5 36.4 21.9 21.9

28.2 37.1 21.5 22.6

Source: IMF, World Economic Outlook April 2006, Statistical Appendix, various tables.

228 The Global Recession Risk

The adjustment of the US may be more complex in practice than in policy discussion and simulations. Table C.3 shows US trade since 1960. The US trade account shifted from surplus to deficit in the 1980s. The deficits escalated to extremely high levels, reaching $377 billion in 2000 and $716 billion in 2005. While exports were higher than imports by 15 percent in the 1960s, they are currently only about two-third of imports. Assuming unchanged imports, exports would have to increase by 56 percent to attain trade balance. Consider the IMF sustainable deficit of 3 percent or about $369 billion. For 2005, that would require exports to be about $1623 billion, increasing by 27 percent. These jumps in variables are not common in reality. There would have to be major worldwide redistribution of wealth, resources and competitiveness to attain even a trade deficit of 3 percent of GDP in the US. To be sure, a movement toward a sustainable US external imbalance could dissipate the market fears that could cause disorderly adjustment. However, such initial movement would have to be prompt and significant. A policy failure or its anticipation could trigger the disorderly correction. However, there may be some hopeful evidence in the adjustment during the second half of the 1980s. Exports increased by 85.2 percent from 1985 to 1990 while imports increased by 49.9 percent. The trade deficit declined by $41 billion or 34 percent. The CAD decreased from about 3 to 1.4 percent of GDP in 1990. The economy performed at capacity. In an earlier episode, exports increased by 134 percent from Table C.3

USA, exports, imports and trade balance $ Million

Period

Exports

Imports

Balance

Exports as % Imports

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005

25940 35285 56640 132585 271834 289070 535233 794387 1070597 1275245

22432 30621 54386 120181 291241 410950 616097 890771 1448156 1991975

3508 4664 2254 12404 –19407 –121880 –80864 –96384 –377559 –716730

115.6 115.2 104.1 110.3 93.3 70.3 86.9 89.2 73.9 64

Source: http://www.bea.gov/bea/di/home/bop.htm

Conclusion 229

1970 to 1975 while imports increased by 120.9 percent. The trade surplus jumped from $2.2 billion to $12.4 billion while the CAD moved from a slight deficit to a surplus of 1.1 percent of GDP. There is significant uncertainty on the issue of global imbalances. The risks of a global recession are sufficiently high to motivate the flood of research and international discussions. However, there are major technical limitations on the theories, measurements and policies, which are common to economics in general. The international official doctrine is based on the single pillar of shared responsibility. Success may prove quite difficult in practice in the international diplomatic effort to coordinate domestic policies affecting employment, output and vested individual and group interests over all regions of the world. If there is predictive value in the theory of disorderly correction, the adjustment will occur by financial decisions of the private sector well before the lagged effects of coordinated action. The elections and parliaments in Germany, Italy, Japan, the US and Mexico show that there is not enough political capital for reforms and policies. There are conflicts in the Middle East and Asia, some of which are related to development of nuclear capacity. The divided Congress in the United States between and within parties may retard or even prevent required reforms.

Appendix Table A

United States, current account and nominal GDP $ billions

1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

Current Account

Nominal GDP

Current Account % GDP

2.8 3.8 3.4 4.4 6.8 5.4 3.0 2.6 0.6 0.4 2.3 –1.4 –5.8 7.1 1.9 18.1 4.3 –14.3 –15.1 –0.3 2.3 5.0 –5.5 –38.7 –94.3 –118.2 –147.2 –160.7 –121.1 –99.5 –78.9 3.7 –47.9 –81.9 –118.0 –109.5 –120.2

526.4 544.7 585.6 617.7 663.6 719.1 787.8 832.6 910.0 984.6 1038.5 1127.1 1238.3 1382.7 1500.0 1638.3 1825.3 2030.9 2294.7 2563.3 2789.5 3128.4 3255.0 3536.7 3933.2 4220.3 4462.8 4739.5 5103.8 5484.4 5803.1 5995.9 6337.7 6657.4 7072.2 7397.7 7816.9

0.5 0.7 0.6 0.7 1.0 0.8 0.4 0.3 – – 0.2 – –0.5 0.5 0.1 1.1 0.2 –0.7 –0.6 – 0.1 0.2 –0.2 –1.1 –2.4 –2.8 –3.3 –3.4 –2.4 –1.8 –1.4 0.1 –0.8 –1.2 –1.7 –1.4 –1.5

230

Appendix 231 Table A

United States, current account and nominal GDP – continued $ billions Current Account

1997 1998 1999 2000 2001 2002 2003 2004 2005

–140 –213 –299 –415 –389 –472 –527 –665 –791

Nominal GDP

Current Account % GDP

8187 8626 9127 9708 10060 10378 11810 11545 12293

Sources: GDP, http://www.bea.doc.gov/bea/dn/home/gdp.htm Current Account: http://www.bea.doc.gov/bea/di/home/bop.htm

–2.5 –2.4 –3.3 –4.3 –3.9 –4.5 –4.9 –5.7 –6.4

Notes 1 http://online.wsj.com/documents/bcom-fuectrade.htm http://www.bea.gov/ bea/newsrel/transnewsrelease.htm 2 http://www.cbo.gov/showdoc.cfm?index=1824&sequence=0 3 http://online.wsj.com/documents/bcom-fuectrade.htm 4 See International Monetary Fund (2003April), Mann (1999a,b, 2002, 2003), Mühlisen and Towe (2004), Reisen (1998), in a vast literature. 5 See Beattie (2005), Coggan (2005), Eichengreen (2004a), Frankel (2005b), Goldstein (2003, 2004), Goldstein and Lardy (2003, 2004), Hufbauer and Wong (2004), Pilling (2005a,b), Prasad, Rumbaugh and Wang (2005), Williamson (2003) and Zebregs (2004). 6 http://news.ft.com/cms/s/8e7fd786-4fa4-11da-8b72-0000779e2340,dwp_ uuid=9ab086aa-462f-11da-8880-00000e2511c8.html 7 Sweig (1995, 765). 8 Cline (2001). 9 Philling (2005c). 10 Lipsky (2003); Wolf (2003). 11 Hughes (2003). 12 International Monetary Fund (2003); Kumar et al. (2003). 13 FDIC (2003). 14 FDIC (2003). 15 Greenspan (1998). 16 Yamagushi (2001); Taylor (2000). 17 Keynes (1936). 18 Krugman (2003). 19 Friedman and Schwartz (1963, 301). 20 Peláez (1972, 1968). 21 Bank for International Settlements (2003). 22 DeLong (1998). 23 Ahearne et al. (2002); Krugman (1998); Baig (2003). 24 Koll (2003). 25 Bank of Japan (2004May); Harui (2003); Inoue (2004); Jopson (2004); Tanabe and McDonald (2004). 26 Ferguson (2003). 27 Latter (2002); N’Diaye (2003); Kamin et al. (2004). 28 Bernanke (2002). 29 Dow Jones Newswires (2003). 30 Tanzi (2003). 31 Feldstein (2002b). 32 Greenspan (2004Apr20). 33 Financial Times, “In Depth: German Elections.” 34 Calvo (1998); Calvo and Reinhart (2000). See Caballero and Krishnamurthy (2001a); Mendoza (2000); Calvo, Izquierdo and Talvi (2003). 35 Burstein, Eichenbaum and Rebelo (2003). 232

Notes 233 36 Ayuso, Pérez and Saurina (2002); Berger, Kyle and Scalise (2000); Berger and Udell (2003); Bernanke and Gertler (1995, 1999); Bernanke, Gertler and Gilchrist (2000); Borio et al. (2000); Carpenter, Whitesell and Zakrajsˇek (2001); Clerc, Drumetz and Jaudoin (2001); D’Amato and Furfine (2003); Ewerhart (2002); Hall (2001); Jackson et al. (1999); Kent and D’Arcy (2000). 37 Fisher (1933). 38 Some references in vast literature include Calvo and Mendoza (1995); Dornbusch, Goldfajn and Valdés (1995); Eichengreen and Rose (1998); Gil Díaz (1995, 2000); Gil Díaz and Casterns (1995, 1996); Krueger and Tornell (1999); White House (1997). 39 Gil Díaz (1995). 40 Recent works of research on Brazil’s financial history include Adams (2003), Armijo (2005), Haber (2000), Hanley (2004), Marichal (1995), Marques de Saes (1995), Musacchio (2005) and Triner (2001). 41 Krugman (2002); Roach (2002); Thurow (2002); World Economic Forum (2002). 42 Board of Governors (1981). 43 http://www.freddiemac.com/finance/cmhpi/past/2005/q3/census9.xls 44 http://www.realtor.org/reioutlook.nsf/pages/regionalperspectives?opendocument

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Index Adalet, Muge, 153–4 ADM, 184–5 Agenda 2010, 117, 142 Alden, Edward, 74, 78 Aliber, Robert, 166 Allen, Mark, 174 Allianz, 64 Amex, 64 AMLO, 155 Areddy, James, 75, 77 Austral Plan, 178, 185 Baba, Naohiko, 82–3, 101 Baig, Taimur, 92 Balls, Andrew, 54, 74, 207 Banco do Brasil, 60, 180 Bank of China, 57, 63–4 Barnett, Steven, 63 Batini, Nicoletta, 112 BCBS, 14, 180, 213 Bergsten, C. Fred, 24, 31–2, 71 Bernanke, Ben, 103–4, 106, 113, 123, 196, 221–3, 225 Billingsley, Patrick, 209 BIS, 87, 121 Black, Fisher, 208 BLS, 116, 135 Bohn, Jeffrey, 208 BOJ Bernanke, 106 current account, 105, 122 exchange rate, 107–8 deflation, 113 BOM, 162 Bordo, Michael, 166 Borio, Claudio, 223 Bradesco, 180 Bretton Woods old, 28, 60, 198, 200 revived, 28, 33–5, 72, 198, 219 Brooks, Ray, 65, 210 Browne, Andrew, 58 Braumann, Benedikt, 142

bubble housing, 22, 74 stock market, 89, 91 Japan, 103 Caballero, Ricardo, 163–4 Calderon, Felipe, 155 Calvo, Guillermo, 148–52 Catão, Luis, 154 Cavallo, Michelle, 195 CBO, 8, 54, 190 CD, 179–80, 182, 184 CDI, 182 Chaboud, Alain, 107 Chiquiar, Daniel, 161 Chan, Ronald, 62 China Construction Bank, 57, 63–4 Citibank, 60 Clarida, Richard, 46–8 Cobet, Aaron, 136 Cooper, Richard, 9, 32–3 Constanzo, Gesualdo, 60 CMHPI, 223–4 Croke, Hilary, 38–40, 192, 203, 215 Cruzado Plan, 178–80 currency manipulator, 71–2 Debelle, Guy, 42 Delfim Netto, Antonio, 168 DeLong, J. Bradford, 87 Denis, C., 138–9 de Rato, Rodrigo, 11, 206 Dickie, Mure, 74 disorderly correction, 10, 19, 38–9, 41, 188, 199, 203, 214, 220–1, 228–9 DLD, 152, 176–7 Dooley, Michael, 33–5, 65, 70 Dornbusch, Rudiger, 12–13, 94, 147 Drummond, Paulo, 143 Duffie, Darell, 208–9 Dunaway, Steven, 63 255

256 Index ECOFIN, 117, 128, 130 Edwards, Sebastian, 48, 148, 153–4 EIA, 124–6 Eichengreen, Barry, 35, 73, 154, 163, 166 EMBI, 17, 147, 158, 161 Estevão, Marcello, 140 European Commission, 16, 116, 137–8 exorbitant privilege, 14, 44–7 Faal, Ebrima, 162 fed funds rate increase, 95, 207 1 percent, 17, 89, 95, 147, 200 policy rate, 17, 95, 103, 212–13, 221 zero, 93 Feldstein, Martin, 95, 117, 130, 196 Feldstein-Horioka, 189, 194–5 FDI Asia, 33 China, 68–9 Brazil, 171–2 Italy, 144 LAC, 158 USA, 23, 30–1, 41, 47–8, 209 Ferguson, Jr., Roger W., 8, 49, 91 financial accelerator, 83, 102, 221–3 Financial Times, 58–9, 78 Finger, Christopher, 208 Folkerts-Landau, David, 33–4 FOMC, 207, 213 Forbes, Kristin, 198–9 Fox, Vicente, 155, 158 Frankel, Jeffrey, 72, 194, 189–90, 197 Frenkel, Jacob, 189 Friedman, Benjamin, 148, 191–2 Friedman, Felice, 143 Friedman, Milton, 214 Freund, Caroline, 40–1 Fukui, Toshihiko, 97, 99–100, 104 FX swap, 183–5 Galati, Gabriele, 42 Garber, Peter, 33–4 Gardarelli, Roberto, 37–8 Geithner, Timothy, 55 GEM, 36, 112

Gertler, Mark, 221, 223, 225 Giambiagi, Fabio, 171 Gilchrist, Simon, 223 Goldfajn, Ilan, 147, 169, 171–3 Goldman Sachs, 64 Goldstein, Morris, 64, 72, 76, 216 Guerrera, Francesco, 57 Gil Díaz, Francisco, 156, 159 Giles, Chris, 25, 54, 207 Giscard D’Estaing, Valéry, 14, 44 Goodfriend, Marvin, 78–9 Gourinchas, Pierre-Olivier, 14, 44–6 Graham, Lindsey, 216 Gramlich, Edward, 192–4 Great Depression, 85–6, 92–3 Green, Stephen, 76 Greenspan, Alan, 13 G7, 10, 14, 17–19, 31, 46, 54, 74, 77, 109, 136, 195, 204, 211, 214, 216–19 G10, 32, 210 Hale, David, 30 Hali, Edison, 109 Haussmann, Ricardo, 163 Hirschman, Albert, 61 Humpage, Owen, 107 Huo, Emily, 62, 67 Industrial and Commercial Bank, 57, 63–4 IFA, 10, 156, 158, 177, 178, 225 IIR, 165 IMFC, 10–11 Ip, Greg, 77 Ito, Takatoshi, 83, 103–6, 108 Iwata, Kazumasa, 96, 105–6 Japan Post, 16, 81, 111 JGB, 83–4, 101, 106 Jiabao, Wen, 74 Katrina, 126 Kealhofer, Stephen, 208 Kim, Kihwan, 32 Kim, Soyoung, 189, 195 Kissel, Mary, 64 Kindleberger, Charles, 166 Koizumi, Junichiro, 16, 81, 215

Index 257 Krishnamurthy, Arvind, 163 Kuijs, Louis, 141–2 Lau, Lawrence, 68 Lane, Philip, 43 Lardy, Nicholas, 64, 76 Laxton, Douglas, 35–6 LBC, 182 Lindsey, Lawrence, 75 Linebaugh, Kate, 64 LDP, 16, 81–2, 215 Lisbon Agenda, 16, 116, 128 lost decade, 16, 81–2, 115, 117–18 Louvre Agreement, 9, 13 LTCM, 12–13, 102, 176 Lssovolik, Bogdan, 143 Maastricht Treaty, 88, 127, 164 maquiladora, 61 McCormack, Richard, 62, 64, 75, 217 McDonald, Brad, 109 McGregor, Richard, 56–7 McKinnon, Ronald, 35, 200 McKinsey, 116, 139–40 Merrill Lynch, 17 Merton, Robert, 208 Milesi-Ferretti, Gian Maria, 35–6, 43 Minella, André, 169, 171–3 Minsky, Hyman, 102 Mishkin, Frederic, 101, 103, 106 MOF, 99, 107–8 Moody’s MKMV, 208 Morse, Andrew, 101 Mundell, Robert, 68, 189–90, 219 Murshid, Panini, 166 Mussa, Michael, 216 NAFTA, 8, 155–6, 161–2 NAIRU, 141, 205 NPL Brazil, 177 China, 38, 62, 69–70, 78 Japan, 81, 83, 86, 102, 107, 110–11 Mexico, 161 SS, 150 Obstfeld, Maurice, 8, 13–14, 22, 28–30, 47–8, 110, 188–9, 197–9, 209, 214

OECD, 40–1, 57, 109, 113, 125, 141, 194, 205, 210, 212 OTN, 181–4, 186 overshooting, 12–13, 28, 32, 173, 214 PAN, 155 Panizza, Ugo, 163 PBC, 62–3, 69–70, 74–9 Peláez, Carlos A., 10, 14, 156, 158, 206, 213 Peláez, Carlos M., 10, 14, 156, 158, 166–8, 178, 185, 206, 213 Plaza Accord, 9, 13, 215 population ageing Brazil, 180 China, 65, 70 Europe, 88 Japan, 95, 104–5, 11 US, 12, 15, 24, 51, 134, 208, 218, 222–3, 225–6 SS, 148–9 PRC, 63, 74 Prasad, Eswar, 63, 67–70, 78–9 PRI, 82 Rajan, Raghuram, 14, 22–3, 28, 72–3, 79, 213, 225–7 Ramos-Francia, Manuel, 161 real estate Brazil, 180 China, 65, 70 Europe, 88 Japan, 95, 104–5, 111 US, 12, 15, 24, 51, 134, 208, 218, 222–3, 225–6 Reinhart, Carmen, 148–50, 164–5, 173 Reinhart, Vincent, 84, 103–4, 106 Rey, Hélène, 14, 44–6 Rey Report, 156 Ricardian Equivalence, 189, 191–2 Ridding, John, 57 RiskMetrics, 208 Rogoff, Kenneth, 8, 13–14, 22, 28–30, 47–8, 110, 188–9, 197–200, 209, 214 Ronci, Marcio, 171 Roubini, Nouriel, 23–7, 32, 189, 195 Royal Bank of Scotland, 64 Rumbaugh, Thomas, 67–9

258 Index Sack, Brian, 103–4 Schnabl, G., 35 Schnure, Calvin, 207–8 Scholes, Myron, 208 Schumer, Charles, 71, 216 Schwartz, Anna, 166 Sekine, Toshitaka, 11 Setser, Brad, 23–7, 32 Sgherri, Silvia, 143 SGP, 117, 121, 127–32, 104 shared responsibility, 9, 11, 18, 214, 227, 229 Singleton, Kenneth, 208–9 Singh, Anoop, 157–8 SOE, 59, 63, 65, 75, 169 SRP, 181–4 Stamicar, Robert, 208 Stiglitz, Joseph, 73–4 Stockman, Alan, 196 Subramanian, Arvind, 72–3 Summers, Lawrence, 24, 31 Suzigan, Wilson, 166–8 Tao, Ran, 65 Tankan, 98, 101 Tanzi, Vito, 94 Tanner, Murray, 75 Taylor, John, 52, 54, 76 Temasek, 64 Terrones, Marco, 37–8

TFP Germany, 143 Mexico, 162 Tille, Cédric, 200, 202 tipping point, 45–6 TOPIX, 82, 84, 96 Trichet, Jean Claude, 119, 121 Triner, Gail, 168 Truman, Edwin, 12, 214 twin crisis, 148, 156 twin deficits, 18, 21, 50, 189–90, 192, 195–8, 200, 207, 219 Valdés, Rodrigo, 147 Von Peter, Goetz, 102 Wang, Qing, 68–9 Wang, Tao, 67 Warnock, Frank, 40–1 Wei, Shang-Jin, 68–9 Williamson, John, 24, 31 Wilson, Gregory, 136 Wriston, Walter, 60 WTO, 57, 65, 68, 79, 90 Wolf, Martin, 25, 28, 30–1 Wolfson, Alexander, 110, 112 Wu, J. R., 62, 69 Zhou Xiaochuan, 74, 77