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|Patterns of international finance|
|Tuesday, 12 October 2010 11:51|
Discussions of current account deficits and surpluses, and their financing are squarely focused on the US deficit and China’s surplus. But there are deficits and surpluses in many other countries that need to be examined. Let’s take a look.
The first thing to bear in mind is that all countries have two types of transactions with the rest of the world, being current account and capital account transactions. The current account is made up of the balance on trade in goods and services, and the net balance on income from overseas investments and borrowing, and things like migrants’ remittances. And if a country has a current deficit, it must be financed by capital inflows like foreign direct investment, portfolio investment, bank lending and investments in government securities.
In other words, a country with a current account deficit is a “capital importer”, as it borrows capital from the rest of the world to finance its deficit. And country with a current account surplus is a “capital exporter”. So when we look at all these current account deficits and surpluses, we should ask ourselves the question, for example, does it make sense for the US to be importing capital (or borrowing) from the rest of the world, or does it make sense for China to be exporting capital (or lending) to the rest of the world.
And when you look into all of this, you can see how we are all tied up together. We are all borrowing and lending to each other. The world’s current account should be balanced (world exports equal world imports) and the world’s capital account should also be balanced (world borrowing must equal world lending).
If we could not conduct international current and capital account transactions, we would be stuck only doing business INSIDE our own countries. This would mean that countries could not borrow from or lend to the rest of the world. This would deny us so many opportunities.
Let’s have a look at a few country cases.
(i) Shortage of finance for development
According to our economics textbooks, finance should flow from rich capital abundant countries to poorer countries with capital shortages. Poorer countries have so many unexploited investment opportunities, and their rate of return on capital should be high.
But the reality is that today many poorer countries are not borrowing money from the rest of the world, but lending money to the rest of the world. A case in point is the Philippines which had a current account surplus of over 5 per cent of GDP in 2009. This country, one of the poorest in Asia, is actually exporting capital to the rest of the world. This phenomenon is called the Lucas paradox, after the economist who identified the problem.
Economic researchers have looked carefully at this issue, and concluded that countries like the Philippines suffer from poor quality “institutions” which make them unattractive for foreign investors – and even unattractive for natives who would prefer to ship their capital overseas rather than investing at home! To attract foreign capital which would improve their development prospects they need to strengthen protection of property rights, reduce corruption, increase government stability, bureaucratic quality and law and order. According to Transparency International, the Philippines is one of the most corrupt countries in the world.
Interestingly, in an earlier period of globalization, from 1880-1914, there were substantial capital flows from rich to poor countries. At the time, most of Asia and Africa was under colonial rule by European powers. Thus, much of the developing world was subject to European-imposed legal and economic arrangements. So a European lender could expect his contract to be enforced with exactly the same effectiveness in Asia or Africa as back home. This is known as the “empire effect”.
(ii) Paradox of plenty
While most developing countries are missing out on international finance, some others are getting too much of a good thing. This was the case in East Asia in the lead-up to the 1997 Asian financial crisis. The region was growing very strongly. Everyone spoke of an East Asian miracle. So there were large flows of capital into the region, as many Western bankers behaved like “herds”. It gave rise to overheating of the economies. It also led to financial fragilities and risks as some people borrowed in foreign currencies to finance local currency investments. Some people also made short-term borrowings to finance long term investments. Then all of a sudden, sentiment changed as foreign investments realized that they had gone too far. And foreign capital then left the region as quickly as it came in, leaving the poor East Asian countries in a crisis situation.
While less serious, in the five years leading up to the global financial crisis, Emerging Asia also experienced a surge in capital flows, which suddenly dried up in 2008.
And now it is on again. The IMF reports that Emerging Asia is experiencing a revival in capital inflows. Total inflows to the region over the past four quarters have more than qradrupled relative to 2008 levels. As global interest rates are low and liquidity is abundant, international investors are attracted to Emerging Asia which is the only part of the world which is growing strongly.
East Asia’s history with hot money shows how dangerous it can be!
(iii) Saving for ageing
Most countries in the world have ageing populations. What this means in practical terms is that the proportion of older people in the population is increasing.
Asia has in particular been experiencing a dramatic demographic transition, from high to low levels of mortality and fertility, over the past fifty years. Prosperity and the associated rise in life expectancy and fall in fertility rates have been the major contributing factors behind this transition. While a similar transition took more than a century in Europe, it has been, and will be, compressed into a few generations in Asia.
Population ageing can have important effects on savings behavior. According to the “life cycle hypothesis” people will try to maintain a constant standard of living throughout their lifetime. In order to do that people will save money during their working years. And when they retire and receive a pension which is lower than their working salary, they will draw down their savings (dissavings) in order to maintain their standard of living beyond retirement age.
The life cycle hypothesis can apply to an individual as well as to a nation. So countries like Germany and Japan which have very rapidly ageing populations have had very large current account surpluses as their populations stashed away populations stashed away money for their retirement. These countries have thus been investing their excess savings overseas. But as population ageing progresses, Germany and Japan will start running down their savings and their current accounts will move into deficit. In the next several decades, old-age populations are expected to grow faster than the working age populations in many Asian countries like Korea, Hong Kong, Singapore and Taiwan.
Most importantly, China is also undergoing rapid ageing due to its one-child policy. Population ageing is unique in China in the sense that China will become “old” before it becomes rich, in contrast to Germany and Japan. And the Chinese government also offers its population very little by way of pensions or free health care, another reason for the Chinese to save.
So one reason why China has a large current account surplus is the effect of its ageing population. Not all of China’s current account surplus would be accounted for by population ageing, but some of it surely is.
(iv) Oil, gas and other commodity producers
Some Middle East oil producers have enormous current account surpluses, countries like Iran, Saudi Arabia, United Arab Emirates, Kuwait and Qatar. Russia, an important gas exporter, also has a large current account surplus, as does Norway.
We can think of several reasons why these countries might have large current account surpluses. First, in many cases, their reserves of oil and gas are limited. They should not just extract these reserves for present consumption. Some of the revenues should be saved so that future generations can also enjoy the benefits of their country’s natural wealth.
Although we have been through a period of high oil prices, historically these prices have been volatile. So it may be wise to save some of the proceeds of these oil and gas exports as an insurance against the future possibility of low prices.
(v) United States
The past 15 years have witnessed a record-breaking rise in the US current deficit – from 1.5 per cent of GDP in 1996 to over 6 per cent in 2006. Although it fell to 2.7 per cent in 2009, the IMF forecast a rise again to 3.2 per cent in 2010.
The US has been absorbing large volumes of savings from the rest of the world to finance its investment. It has required such savings because its own savings fell to very low levels. The government budget moved into deficit under President George Bush. In addition, in the years before the crisis private savings also fell to low levels, in part because private asset levels rose thanks to the housing price boom. The government budget is still in deficit as the government tries to stimulate the economy, while private savings has now rebounded up as consumers try to restore their financial situations after the crisis.
In the lead-up to the global financial crisis, many observers were worried that the US would suffer from a nasty change of sentiment. Foreign investors could have suffered from “dollar indigestion” leading to sudden decline in the value of the dollar and instability for the whole world economy. In the event, this did not happen. But the present very high US budget deficit and debt buildup create risks of a future loss of confidence in the dollar.
There are other views on the US situation. For example, US Federal Reserve Chairman argues that one of the factors driving the increase in the US current account deficit was a “global saving glut”. This was due to large emerging economies like China, as well as oil exporters, shifting from the status of capital market net borrowers to net lenders.
And lastly, there are observers like Richard Copper who see no problem with the US current deficit. He claims that the US current account deficit is due to foreigners wanting to invest in the US for several reasons. Its population is ageing much less than in Europe or Japan. Also, it has a very dynamic economy with a very sound policy and legal framework which protects investors.
China’s current account surplus rose to some 11 per cent of GDP in 2007, and only fell to 6 per cent in 2009. There are many factors behind this. First, China’s rapidly ageing society provides an incentive for Chinese citizens to save.
Second and most importantly, China subsidizes its exports in several ways. Multinational enterprises which account for close to 60 per cent of China’s exports undertake processing trade (assembling manufactured products from imported components) in export processing zones which are given many advantages like low land costs, tax holidays, duty free imports, etc. In addition, large Chinese state-owned enterprises do not pay dividends and also get cheap access to land, energy etc. However, the most important way that China subsidizes its exports is through keeping its exchange rate basically fixed at a low level. Although it had a managed appreciation from 2005 to 2008, it was then fixed again until a few months ago. Although it is now in principle managed again, it has barely moved for months.
This subsidization of exports provides many benefits to the people involved in manufacturing exports. But, it does not make economic sense to be exporting so much savings to the rest of the world when China still has much poverty. Although only 8 per cent of Chinese now live on less than $1 per day, some 50 per cent still live on less than $2.50 a day. In other words, a large share of the Chinese population has only climbed up one rung of the ladder out of poverty. The Chinese government should be using its surpluses to help its own poor people rather than investing in US Treasury Bonds. Further, a revaluation of the exchange rate would make imports cheaper for all Chinese.
Some concluding comments
The external imbalances of both US and China do not make much sense, and have many negative effects. The US current account deficit is being driven in large part by its budget deficit which is not being wisely invested. The US also needs to prepare for population ageing, even if its population is ageing more slowly than those of Germany and Japan. Private savings also needs to be encouraged.
The Chinese current account surplus is not benefiting the broad Chinese public. It does not make economic sense for China to be investing so much of its savings overseas.
From the point of view of current account imbalances, both sides should undertake actions to reduce their respective current account deficits and surpluses.
But there is more to it than this. The world economy is struggling to climb out of the Great Recession caused by the Global Financial Crisis. In past crises, like the Mexican peso crisis and the Asian Financial Crisis, crisis-affected countries were able to export their way out of crisis, principally by exporting to the US.
Now many parts of the world would like to export their way out of crisis especially the US and EU. But it is impossible for everyone to export their way to recovery. For every exporter there must be an importer. World exports must equal world imports. Everyone also wants a low exchange rate. Again, this is impossible. Exchanges rates are just one currency in terms of another. They are a relative concept. Everyone cannot be low.
But the only part of the world which is growing and is capable of absorbing exports from the rest of the world is China and the rest of emerging Asia. But China refuses to budge. It will not revalue its exchange rate, despite pressure from not only the US, but also the EU and Japan. This has led to discussions of a possible currency war at the recent IMF meetings.
Something has to give. Could this be the moment for a “black swan event”? Nassim Nicholas Taleb developed the theory of “The Black Swan” to explain events which are unpredictable, and which have a major impact, but which can be easily rationalized after the event, as if they had been expected. For Taleb, life and history is dominated by black swan events like the end of the Cold War, 11 September, the rise of the Internet and even the global financial crisis.
There is too much electricity in the system now. Something shocking or surprising could happen. A black swan could be on the horizon. But don’t worry, after the event, we will be able to explain it very easily, even if we cannot predict it now!
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