The great global rebalancing and its implications

March 29, 2011

Manoj Pradhan

Alan M. TaylorManoj Pradhan, left, a global EM economist, is an executive director at Morgan Stanley. Alan M. Taylor, right, a senior advisor at Morgan Stanley, is a professor of economics at the University of California, Davis. The opinions expressed are their own.

Policymakers have fretted about global imbalances for nearly a decade, but little consensus or clarity has emerged. Some saw problems created by surplus countries, others deficit countries. Many feared a fiscal-cum-balance of payments crisis in the U.S., but the crisis we got reflected private/financial failures. G20 proposals for collective action remain a work in progress. Uncoordinated policy actions triggered talk of currency wars.

As these debates drone on, there may be less cause for concern about global imbalances. Emerging market-developed market (EM-DM) relationships may revert to a more typical historical pattern. We highlight key areas of global adjustment in this scenario: shifts in capital flows, exchange rates and real interest rates.

The peculiar global macro configuration of the last 15 years was unprecedented. Capital flowed “uphill” from poor to rich countries — EMs saved more than they invested, the excess showing up as current account surpluses (net exports of EM goods) and financial outflows (net acquisition of DM assets). But digging deeper exposed a crucial fact: private capital still flowed “downhill” to EM economies in line with intuition, but offset by even larger “uphill” official flows, the reserves bought by EM central banks and sovereign wealth funds.

Despite allegations of strategic undervaluation, mercantilism, and the like, EMs had good reason to accumulate reserves as a precautionary measure. They had learned painful lessons from past crises. A loss of capital market access or sudden stop, or a bank/currency run or sudden flight, could trigger a vicious risk spiral linking currency crashes, banking panics and default.

In the 1997 Asian crisis, IMF help was seen as slow, limited, expensive and laden with unpleasant policy conditionality; economies, and their political leaders, suffered heavy damage. Reserve war chests were a “self insurance” response, obviating the need to rely on the kindness of strangers.

This reserve asymmetry is the first trend of note, a step-change in policy by EM countries in response to the 1990s crises. From 1990 to 2007 EM reserves rose from $195 billion to $4,284 billion (or from 4% of EM GDP to 21%). But is this now an ample war chest? Recent events suggest the answer is yes.

The 2008 crisis is the largest global shock since the Great Depression. Yet no EM country suffered any form of crisis, with reserves on hand to support currencies, insure against capital flight, fund fiscal stimuli and so on. Such a benign outcome was unthinkable a few years ago. While EM reserves might still grow gradually to track EM expansion, a continued aggressive step-change to augment reserves relative to GDP seems unlikely, as current war chests are evidently large enough to cope with severe macroeconomic disasters.

The other trend of note is growth asymmetry. Obviously, the recovery has been strong in EMs, weaker in DMs. But ongoing divergence could be driven by deeper fundamentals.

Near-term investment demand should be cyclically high as DM and EM make up for a pronounced “wait and see” postponement of capex; but the rebound may be larger in higher-growth EMs. This puts greater weight on EM investment going forward, an asymmetry amplified by the EM’s growing weight in global GDP.

Meanwhile saving supply will likely fall. Globally the demographic burden provides a drag. In EM economies an offset may arise from milder precautionary saving (public and private) as their economic model has proved itself resilient. DM economies, although faced with deleveraging and/or austerity, may see saving remain flat or decline, given their greying populations.

Thus, we see lasting consequences beyond those unfolding in the immediate aftermath of the financial crisis:

  • A huge rise in demand for capital in EMs with a more moderate increase in DMs. Talk of a savings glut or an investment drought may recede. The global real interest rate is likely to rise.
  • Less saving flows out of EM economies. Growth prospects are the main driver but risk premia for newly resilient EMs may fall. If investment demand is muted in DMs, and saving flat, the shift is weaker in DMs. Global imbalances moderate, reinforcing the trends after the crisis.
  • These current account shifts cannot be an “immaculate transfer” without real exchange rate adjustment. Recent real appreciation of EMs took the form of relative inflation and managed currencies (the latter creating political distractions). But EMs are likely to absorb further adjustment through nominal appreciation, given a triple whammy of cyclical reflation, growth differentials pushing nontradable inflation and oil/commodity price shocks.

Policymakers risk fighting the last war as macro-financial dynamics shift in the post-crisis era. The Great Reserve Accumulation was a response to specific historical circumstances: the once-in-a-history opening of emerging markets to economic and financial globalization and its attendant risks.

Emerging and developed economies may be engaged in a rather different dance as the next phase of global economic history unfolds.

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