Global Imbalances

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Global Imbalances With a focus on the U.S. and
China Jane Sneddon Little Vice President and
Economist Federal Reserve Bank of
Boston Presented to Three Day Teacher Workshop
on Globalization and International
Economics Federal Reserve Bank of Boston Boston,
MA July 6, 2006 The views expressed in this
presentation are those of the presenter and do
not reflect positions of the Federal Reserve Bank
of Boston or the Federal Reserve System. Selva
Baziki and Teresa Foy prepared the charts.
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• General Plan
• Global Imbalances a Cause for Concern?
• U.S. Current Account Deficit
• Why it has developed
• What it would take to correct it
• Chinas Current Account Surplus
• Why it has developed
• What it would take to correct it
• What the U.S. can do

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• Focusing on the U.S.
• Possible disorderly correction of the U.S.
  current account deficit a key risk
• Why has the U.S. current account balance
  deteriorated?
• Accounting perspective
• Structural perspective
• Are recent trends sustainable?
• Requirements for substantial improvement
• A pick up in foreign demand growth and/or
• Further dollar depreciation (a joint decision)
  and/or
• Focus on China
• Increasing U.S. saving relative to US investment
• Policy options
• Monetary policy blunt instrument
• Fiscal policy can be focused

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Large global imbalances the huge U.S. deficit
plus offsetting surpluses in OPEC and Asia
represent a key threat to the global outlook.
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The U.S. current account deficit has become
unusually large relative to GDP and remains
unusually persistent.
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The decline in the U.S. current account largely
reflects trends in the trade balance. In future,
net income flows are likely to turn negative too.
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Why has the current account worsened? Because
U.S. consumption and investment have grown faster
than U.S. output, and foreigners have lent us
funds for imports to fill the gap.
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Equivalently, U.S. investment increasingly
exceeds U.S. saving...
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as foreigners have willingly financed a growing
fiscal deficit plus modest net borrowing by the
private sector
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...although in recent quarters official investors
have often played a major role.
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Domestic saving has declined in all sectors but
the corporate.
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Why has the personal savings rate declined? One
important reason may be the rise in housing
wealth and financial innovations that let home
owners tap into it.
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As U.S. current account deficits have persisted,
U.S. net debt to foreigners has grown to almost
25 percent of GDP - an unusually big share for a
large, wealthy country.
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• The U.S. current account deficit cannot continue
  to grow faster than GDP.
• Correcting the U.S. current account imbalance
  will require some combination of
• Significantly faster foreign demand growth, and
  thus, more U.S. exports
• Additional dollar depreciation, shifting
  production to the U.S. and consumption overseas
• Raising U.S. savings relative to U.S. investment

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The first alternative is desirable but unlikely,
given recent trends in productivity and
population growth that suggest that U.S.
potential growth will outstrip that in other G-10
countries over the medium term.
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Turning to the exchange rate, the trade-weighted
dollar has fallen by about 13 percent since its
recent peak in early 2002 - far less than its
decline in the 1980s.
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In addition, the "pass through" of the impact of
dollar depreciation to import prices seems to
have declined over time
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while the impact of non-oil import prices on
core inflation is very muted.
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• Focusing on China
• China is causing considerable concern because it
  is viewed as
• A formidable competitive threat
• A large net lender to the United States
• The competitive threat
• Reflects Chinas low unit labor costs
• Will decline with
• - Gradually rising labor compensation
• - Cautious RMB appreciation
• China has a large savings glut
• Because institutional factors deter capital
  inflows to China
• Because a weak safety net, demographic trends
  and
• immature capital markets encourage savings

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In China, where the trade surplus equaled about
4.8 percent of GDP in the first half of 2005,
surpluses with the U.S. and EU more than offset
deficits with suppliers of components and
commodities.
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China is stirring congressional interest because,
as a successor to Japan and the Asian NICs as a
major exporter of labor-intensive goods, it now
accounts for one-fourth of the U.S. trade deficit.
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Many of the goods we import from China are no
longer widely made in the U.S. Still, U.S.
producers are clearly aware that China's export
bundle is quickly growing more sophisticated.
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While China's wages are indeed low, they reflect
China's generally low labor productivity, which
offsets much of China's wage advantage. Further,
the gap between U.S. and developing country labor
costs tends to narrow over time.
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And China will almost surely follow the same
path wages are already rising rapidly,
especially in coastal areas.
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In China, however, shifts in surplus labor from
agriculture and the state-owned enterprises to
more productive urban manufacturing jobs will
likely slow the rise in China's manufacturing
costs for some time.
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• RMB appreciation offers an alternative way to
  equalize U.S. and Chinese labor costs.
• On July 21st China announced a new foreign
  exchange regime
• De facto dollar peg became a "managed float"
  based on a basket of currencies
• RMB revalued by 2 percent against the U.S.
  Dollar
• Exchange rate can move up or down by 0.3 percent
  per day from its central rate
• Each day's closing rate becomes the next day's
  central rate.

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Since last July, when China ended its dollar peg,
the RMB has gained just 3.3 percent vs. the
dollar. Estimates of an appropriate appreciation
average 30 percent. Why is China still managing
the RMB?
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• Why are the Chinese so cautious about RMB
  revaluation?
• A large appreciation and increased flexibility
  might hurt
• The agricultural sector
• The inefficient SOEs
• The banking system
• They are less concerned that
• Capital inflows may undermine their monetary
  policy
• Accumulating reserves could be expensive
• Reserve funds might be put to better use

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although a recent acceleration in bank loans and
inflation has prompted policy restraint.
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From a U.S. view, foreign official assets are too
small a share of total U.S. credit and equity
outstanding for net foreign official purchases or
sales of U.S. securities to have a big impact on
interest rates in U.S. financial markets.
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To reduce its trade surplus, China could also
address its savings "glut" directly. China is
after all a low-income developing country that
"should" borrow abroad. Why is it saving even
more relative to GDP than its extraordinarily
high investment rate? Institutional barriers may
deter capital inflows...
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To reduce its trade surplus, China could also
address its savings "glut" directly. China is
after all a low-income developing country that
"should" borrow abroad. Why is it saving even
more relative to GDP than its extraordinarily
high investment rate? Institutional barriers may
deter capital inflows.
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China was largely "closed" to foreign investment
from 1949 to 1989 and still remains in transition
from a centrally planned to a market-based
economy. Many impediments still restrain inbound
FDI.
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• Additional Reasons for Chinas High Savings Rate
• Inadequate social safety net
• New 5-Year plan calls for increased spending on
  social services
• Limited financial development
• Financial system will evolve , especially with
  the entry of more foreign institutions as per WTO
  agreement
• Demographic trends
• Aging population will begin to withdraw savings
• But current developments suggest that the
  savings rate will soon start to trend down.

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• Conclusions Regarding China
• Judging from history and current trends
• Chinese labor costs will rise
• The RMB will appreciate
• Chinas savings rate will fall relative to
  investment
• In other words, recommended adjustments will
  occur gradually on Chinas schedule
• While Chinas likely path to balance tells us
  little about how U.S. adjustment will occur,
  overall, Chinas ongoing maturation will almost
  surely have important economic benefits for the
  United States.

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What can the U.S. do? With output near
potential, how can U.S. policy narrow the trade
gap without re-opening the output gap? Monetary
policy is a rather blunt instrument, affecting
both consumption and investment.
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By contrast, fiscal policy can directly target
consumption and encourage saving - via a
consumption tax, say. Or the government can
reduce its own dissaving. Despite private sector
offsets, the outcome is more likely to be higher
savings, not lower investment.
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• Key Points
• Todays large payments imbalances reflect major
  mismatches in savings and investment in the U.S.
  and abroad.
• Correcting these unsustainable imbalances in an
  orderly fashion represents a major challenge to
  world policy makers.
• With potential growth expected to remain higher
  in the U.S. than abroad, a pickup in foreign
  demand growth is unlikely to provide the primary
  solution.
• And while increased exchange rate flexibility in
  emerging Asia could prove widely beneficial, by
  itself, further gradual dollar depreciation is
  unlikely to correct the U.S. current account
  deficit.
• Since fiscal restraint can be targeted to affect
  consumption and specific types of investment,
  like housing, tighter U.S. fiscal policy
  represents a promising route to adjustment.
• Elsewhere, ongoing structural reforms to
  encourage greater labor force participation in
  Europe and Japan, say, or to develop a social
  safety net in China could also make important
  contributions.