Published on April 9, 2008
The International Economic Environment: The International Economic Environment Current Crisis What causes CA deficits and surpluses? The origins of the US trade imbalance Sustainable or Source of Concern? Impact on the $ Impact on firm profits Bernanke: Why is the United States, with the world’s largest economy, borrowing heavily on international capital markets — rather than lending, as would seem more natural? Global Trends : Global Trends Dichotomy beginning to develop between OECD and Emerging economies. US stalling due to falling housing prices, high energy prices and credit crunch. China and India will likely emerge unscathed. Several other OECD economies will also be hit by high energy prices, falling housing prices and appreciating currencies. Potential problems – large imbalances of trade leading to $ fall… “The global imbalances probably represent the single largest current threat to the continued growth and stability of the US and world economies (Bergsten, 07)” “U.S. CA deficit as a sword of Damocles hanging over the global economy (Rogoff 07).” US borrows over $8 billion a working day from world markets, and experienced a record $857 billion CA (-7% GDP) deficit in 06, breaking 2005 $717 billion record. In 2007, CA projected to exceed $800 billion. China experienced a record $250 billion in 2006, about 9% of GDP, double the record 2005. “China’s CA surplus in 2007 will reach $400–$420 billion, 12 % GDP. A surplus of this magnitude relative to GDP “would be unprecedented for a country of China’s size and stage of development” (McGregor 2007). US economy: US economy Housing has been a BIG component of our recovery since the last recession – contributing jobs, fueling consumption. Housing Price, Sales and Construction DOWN in 3rd Q 07 housing prices fell fastest in 20 yrs. 4th Q Homebuilding declined largest in 27 years, and good predictor of recessions. Credit Market Meltdowns – Subprime Lending may lead to $200 billion in losses and $2 trillion lending cutback. Fed is constrained as pumping in $, lowers interest rates and $. Fuels inflation. Excess liquidity of past several years is responsible for much of our problems, and Fed unlikely to repeat mistakes. The high food and energy prices further constrain Fed actions. Foreclosures have doubled, Credit card and auto defaults have risen 50% over 18 months. Zero personal savings and less home equity withdrawals imply household piggyback is empty. Consumer may no longer be engine of growth. Consumer Confidence…? Wall Street? Slowdown…Recession? The Unfolding Crisis: The Unfolding Crisis “The first major financial crisis of the 21st century involves esoteric instruments, unaware regulators, and skittish investors. It also follows a well-trodden path laid down by centuries of financial folly. Is the “special” problem of sub-prime mortgages this time really different?” (Reinhart and Rogoff, 08) Their examination of dozens of currency and debt crises finds stunning qualitative and quantitative parallels across a number of standard financial crisis indicators. They find that although the buildup up debt is less, the pattern of US CA deficits is markedly worse. The aftermath of other episodes suggests that the strains can be quite severe, typically leading to fall of GDP by 2% and a prolonged 2-year slowdown. Rogoff – “Starting in the summer of 2007, the US experienced a striking contraction in wealth, increase in risk spreads, and deterioration in credit market functioning. The 2007 US sub-prime crisis, of course, has it roots in falling housing prices, which have in turn led to higher default levels particularly among less credit-worthy borrowers. The impact of these defaults on the financial sector has been greatly magnified due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, that innovation also made the resulting instruments extremely nontransparent and illiquid in the face of falling house…” The Unfolding Crisis: The Unfolding Crisis “Tolstoy famously begins his classic novel Anna Karenina with “Every happy family is alike, but every unhappy family is unhappy in their own way.” While each financial crisis no doubt is distinct, they also share striking similarities, in the run-up of asset prices, in debt accumulation, in growth patterns, and in current account deficits. The majority of historical crises are preceded by financial liberalization, as documented in Kaminsky and Reinhart (1999). While in the case of the US, there has been no striking de jure liberalization, there certainly has been a de facto liberalization. New unregulated, or lightly regulated, financial entities have come to play a much larger role in the financial system, undoubtedly enhancing stability against some kinds of shocks, but possibly increasing vulnerabilities against others. “Perhaps the US will prove a different kind of happy family. Despite many superficial similarities to a typical crisis country, it may yet suffer a growth lapse comparable only to the mildest cases. Perhaps this time will be different as so many argue. Nevertheless, the quantitative and qualitative parallels in run-ups to earlier postwar industrialized-country financial crises are worthy of note.” Global Imbalances: Global Imbalances “These global imbalances are unsustainable for both international financial and US domestic political reasons. On the intl side, the US must now attract $8 billion of capital from the rest of the world every working day to finance the US CA deficit and foreign investment outflows. Even a modest reduction of this inflow, let alone its cessation or a sell-off from the $14 trillion of dollar claims on the US now held around the world, could initiate a precipitous decline in the $. This could, in turn, sharply increase US inflation and interest rates, severely affecting the equity and housing markets and potentially triggering a recession.” Fred Bergsten May 07 “The world economy faces an acute policy dilemma that, if mishandled, could bring on the mother of all monetary crises. Many dollar holders, including central banks and sovereign wealth funds as well as private investors, clearly want to diversify into other currencies. Even a modest realization of these desires could produce a free fall of the US currency and huge disruptions to markets and the world economy. Fears of such an outcome have risen sharply in both official circles and the markets. ” Bergsten Dec 07. Impact on US Ownership: Impact on US Ownership Foreigners account for about $2.2 trillion, or a little over half, of the outstanding total of $4.3 trillion of US Treasury securities held by the public. Official institutions, mainly central banks, account for about 60 percent of this total. In addition, foreigners as a whole probably hold close to $1 trillion, or about 15%, of US government agency securities. These totals and ratios have risen rapidly over the past 20 years. From 1985-06, foreigners acquired almost 75 percent of the overall increase in outstanding treasuries. From 1995-06, domestic holdings actually fell while foreign holdings grew by twice the aggregate increase. Since 2001, foreign purchases of treasuries have accounted for most of the rise in the total outstanding debt. Hence, the CA is now being financed by short-term money and by central banks, which is unprecedented. FX reserves (65% in $) have risen by $1 trillion in just 18 months. The previous addition of $1 trillion to official reserves took a decade. These purchases of $ have nothing to do with the prospective returns in the US, but are aimed at holding down the currencies of the purchasing countries. Worse still, in recent years capital inflows into America have been financing not productive investment (which would boost future income) but a consumer-spending binge and a growing budget deficit. A CA deficit that reflects a lack of saving is hardly a sign of strength. Debt is 11 times export earnings and comparable to crisis victims such as Argentina and Brazil China’s Role: China’s Role China has blocked any significant rise in the RMB by intervening massively in the FX markets, buying $15–20 billion per month for several years to hold its currency down, allowing very modest appreciations. Chinese intervention doubled recently to about $45 billion per month. Since it continues to link the RMB to the falling $, China’s effective exchange rate is weaker now than in 2001 when it CA surplus = 1.3% of GDP. “The world’s most competitive economy has become even more competitive through a deliberate policy of currency undervaluation.” By keeping its own currency undervalued, China has deterred a number of other Asian countries from letting their currencies appreciate against the $ for fear of losing competitive position against China. Hence China’s currency policy has taken much of Asia out of the intl adjustment process. This point is critical as Asia accounts for about half the global surpluses that are the counterparts of the US CA deficit. This is unlikely to continue, and the RMB has in the last 3 months “stealthily” appreciated. Why? Reserves have reached $1.5 TRILLION. China’s Reserves and RMB: China’s Reserves and RMB “It is important to note that the relative importance of the CA and KA surpluses as contributors to the reserve build up has changed dramatically. In 2004, the KA surplus was more than half again as large as the CA surplus and thus accounted for most of the reserve build up. In 2005, however, the CA surplus was 2.5 times the KA surplus By 2006, the CA surplus was 25 times the KA surplus and accounted for the entire reserve build up (Thus, for 2005 and 2006, it is incorrect to argue that China’s rapid reserve build up was due primarily to large capital inflows rather than a growing current account surplus.” Goldstein 07 Equilibrium exchange rate is defined as the rate that brings CA in balance. Estimated that RMB is 20% undervalued. Recent work also shows revaluation will help Chinese economy by lowering oil prices, moderate investment and stimulate consumption. Balance of Payments: Balance of Payments Anything that we buy or sell to the rest of the world must be paid for. The current account (CA) tracks the flow of goods and services between the US and the rest of the world and Net Exports of Goods and Services, Net Income (from investments and wages) and Net transfers The capital & financial account tracks the payments for those goods & services (KFA) and records the purchase and sale of financial and non-financial assets. It includes Official international transactions which central banks collect as reserves. CA + KFA = 0 CA imbalance: CA imbalance Y= C+I + G+X-M Income = Spending Y- (C+I+G) = NX Income – Spending = borrowing. S-I = NX Trade balance = net investment Hence, a NX deficit is determined by too much spending, too little savings. US record trade imbalance occurs due to record low savings and large government deficits. Borrowing to finance investment. Net investment position – cumulative lending-borrowing gone from $3 trillion to -$2.7 trillion in a decade. Saving and investment balances compared: Saving and investment balances compared IMF: Because a country's CA deficit is the difference between what it invests and what it saves, it is instructive to analyze the relative importance of changes in investment and changes in savings in explaining where we are. The increase in the U.S. CA deficit that took place during the 2nd half of the 1990s is attributable to an increase in U.S. private sector investment, and not to a fall in saving. Since 2000, however, the increase in the current account deficit has reflected mostly a decline in private public sector saving because of the growing fiscal deficit and a further decline in an already low household savings rate. Private investment, despite its welcome pickup since 2003, remains below mid 1990s. Asian CA imbalances: Asian CA imbalances In the ASEAN countries and the NIEs, the increased current account surpluses result from a marked drop in investment, largely a reaction to the excessive investment prior to the 1997-98 crisis. In Japan also, investment has fallen steadily following the bubble years. By contrast, the savings rate did not change much in all these countries, so they started running large surpluses. Finally, China is the exception in that investment has continued growing in the last few years, but it runs a large surplus because savings have grown even faster. The savings-investment analysis suggests we need greater savings in the United States, stronger growth in Europe and Japan, higher investment in the ASEAN and NIEs, and greater consumption in China to narrow the imbalances. I will talk soon about policies that will be needed. But first, assuming that policies are in place to effect the adjustment, how will exchange rates have to move to help the adjustment. Potential $ instability: Potential $ instability Economist: “America's policies are putting at risk the dollar's role as the world's dominant international currency. IMF - With its rising budget deficit and ballooning trade imbalance, the United States is running up a foreign debt of such record-breaking proportions that it threatens the financial stability of the global economy. IMF reported sounded a loud alarm about the shaky fiscal foundation of the US, questioning the wisdom of the Bush administration's tax cuts and warning that large budget deficits pose "significant risks" not just for the US but for the rest of the world. The report warns that the United States' net financial obligations to the rest of the world could be equal to 40 percent of its total economy within a few years — "an unprecedented level of external debt for a large industrial country," according to the fund, that could play havoc with the value of the dollar and international exchange rates. The danger, according to the report, is that the United States' voracious appetite for borrowing could push up global interest rates and thus slow global investment and economic growth. "Higher borrowing costs abroad would mean that the adverse effects of U.S. fiscal deficits would spill over into global investment and output," The I.M.F. is right," said C. Fred Bergsten, director of the Institute for International Economics in Wash. "If those twin deficits — of the federal budget and the trade deficit — continue to grow you are increasing the risk of a day of reckoning when things can get pretty nasty." Why has Asia sustained the $: Why has Asia sustained the $ Why are they lending us $100s Billions? What has prevented correction and lead to a Bretton Woods II Benefit? US China/Japan Cost? US China/Japan Is the symbiosis stable where we buy goods and Asians buy bonds? BW II vs BW I : BW II vs BW I US ran large CA balances under BWI but they are unsustainable under BWII Capital Flows Much Greater NOW There is an alternative today (Euro) History and cooperation on BWI (used to fixed e and Europe cooperate w/US) Only some countries adopt BWII (Asia) and there is apprehension about $ volatility Reserves are overheating China and hurting Chinese Banks. Russia & Middle East beginning to diversify reserves Blame China and Japan: Blame China and Japan If only Asia would save less, spend more and so import more from America, it is argued, the deficit would simply vanish. The problem is that America's imports are 50% bigger than its exports, so if exports and imports simply grow at the same pace, the trade deficit automatically widens. If imports rise by, say 10%, then exports need to grow by 15% just to prevent the deficit from widening. This means that while stronger foreign demand would undoubtedly help, it would be virtually impossible for America to reduce its deficit significantly through stronger exports alone. Li Ruogu, the deputy governor of the People's Bank of China, said that America should put its own house in order—ie, save more—and stop blaming others for its problems. Europe: Europe In the 90s, slow growth in big Euro countries, particularly Germany (1/3) due to hangover from unification, high taxes, and labor regulations have lead to worst growth of all Western European economies in last decade save Italy. Germany, Italy, France: low domestic demand, interest rates too high, high savings. Future problem: demographics, competitiveness, social programs. Inward Looking. Germany growing now due to exports, Spain, Ireland and UK are experiencing large CA deficits and housing boom hangovers. Effective Exchange Rate: Effective Exchange Rate Nominal EER is the weighted basket of exchange rates of a nation’s trade partners Real EER is a weighted basket adjusted for differences in exchange rates. A depreciation (currency is becoming less valuable) in the Real EER implies an improvement in the CA, though it typically takes a year, though it maybe small if there is pricing to market Exchange rates : Exchange rates Pricing to Market: Pricing to Market Pricing to Market occurs when foreigner producers price their goods in the domestic market relative to domestic competition, and implies that movements in exchange rates don’t affect domestic consumers, but foreign producers. A depreciation of the $ leads not to higher prices of Lexus, but lower profits of Lexus manufacturer. Has increased in US from 50% to 70%, implies that US depreciation must be large to affect CA. Exchange Rate change Effects: Exchange Rate change Effects A substantial body of empirical work documents that exchange rate pass-through to prices is delayed and incomplete (Engel, 1999; Parsley and Wei, 2001; Goldberg and Campa, 2006). These studies show that the prices of tradable goods respond sluggishly and incompletely to variations in the nominal exchange rate. An increase in the exchange rate leads to a substantially less than proportional increase in traded goods prices; and much of the price response occurs with a substantial delay. Recent theoretical work has suggested a number of potentially important factors in explaining incomplete pass-through. What prices are affected by exchange rate movements ? Do the consumer prices entirely reflect these changes or are there adjustments of exporting firms’ margins ? What determines effects : if the degree of pass-through is seen as a strategic decision for exporting firms, what kind of factors can influence those strategies ? Are the determinants rather micro or macroeconomic? Exporters often take into account the currency changes when fixing their price, explaining the incomplete pass-through observed at the aggregated level on import prices $ Changes and Profits: $ Changes and Profits Honda Motor claims that “every ¥en the dollar rises against the Japanese currency adds about $40 million to its profits.” Why is Honda’s profit related to the strength of the dollar? Who benefits from a $ fall? ¥en/$ in the 1990s: Implications for Honda’s Profits: ¥en/$ in the 1990s: Implications for Honda’s Profits 1990 to 1995: 150 ¥en/$ to 90 ¥en/$ Profit change = ($40 mill)*(-60) = -$2.4 billion 1995 to 97: 90 ¥en/$ to 125 ¥en/$ Profit change = ($40 mill)*(35) = +$1.4 billion Price and Output Response to a Depreciation of the Exporter’s Currency: Price and Output Response to a Depreciation of the Exporter’s Currency quantity ¥en MC MR1 q1 p1 optimal price and quantity rise as a result of depreciation of the exporter’s currency for a given MC Profit Response to a Depreciation of the Exporter’s Currency: Profit Response to a Depreciation of the Exporter’s Currency quantity ¥en MC q2 q1 p2 p1 depreciation of exporter’s currency increases price, quantity, and profit Linkages between US and ROW: Linkages between US and ROW trade, capital flows and FDI (Europe, Japan, Emerging markets), value of the US dollar, US monetary and fiscal policy, global stock market links, IT sector performance, developments in oil prices, political risk.