Morgan Stanley - Global: Imbalances Matter More than Ever - Stephen Roach

Morgan Stanley <>Global: Imbalances Matter More than Ever - Stephen Roach (from Venice)

It is precisely because imbalances matter more than ever that I have changed my assessment of global macro risks (see my 1 May dispatch, “World on the Mend”). For me, the macro-analytic framework is the core of my value system as an economist. And the anchor of my global view has long been -- and continues to be -- the unsustainable imbalances that have opened up between the world’s creditors and debtors. That has not changed one iota. What has changed are the inputs that are fed into this thought process. They now point to a more benign strain of global rebalancing than I had previously thought. As Lord Keynes famously quipped, “When the facts change, I change my mind. What do you do, sir?”

The imperatives of global rebalancing have never been greater. By our reckoning, the disparity between the world’s current account surpluses and deficits will hit an astonishing 6% of world GDP in 2006. Moreover, the deterioration is occurring at unprecedented speed. If our forecast comes to pass, this year’s divergence between surpluses and deficits will be fully 50% higher than the 4% gap of 2003. And the asymmetry of the world’s imbalances remains one of its most problematic characteristics: The surpluses are broadly diffused, whereas the deficits are highly concentrated; last year, the US accounted for about 70% of all the current account deficits in the world. This asymmetry underscores the precarious nature of the global disequilibrium. With the three largest surplus nations -- Japan, China, and Germany -- all hard at work in stimulating internal demand, there is a growing likelihood that their surplus saving will decline. That will put even more pressure on the funding of the largest external deficit in recorded history.

But why can’t this state of affairs persist indefinitely -- living up to its billing by some as the world’s first sustainable disequilibrium? This gets to the essence of the “new paradigm” thinking that has infatuated many in the world of international finance. In its simplest form, the so-called “Bretton Woods II” framework views Asia as part of an expanded dollar bloc. America, the consumer, is presumed to have a perfectly symbiotic relationship with Asia, the producer. The relationship is cemented by Asia’s quasi dollar pegs, which guarantee an automatic recycling of the region’s massive build-up of foreign exchange reserves into dollar-denominated assets. To the extent that this recycling pushes US interest rates lower than might otherwise be the case, asset-dependent US consumers enjoy a special subsidy from their foreign lenders. As depicted in this fashion, America’s consumption binge appears to match up perfectly with the Asian producers’ open-ended demand for dollars. Who could ask for more?

To answer this question, it helps to simplify the world down to two major actors -- China and the United States. While the world in general and Asia, in particular, are full of export-led economies who recycle foreign exchange reserves into dollars, China is in a league of its own. Last year, China added about $200 billion to its reservoir of official currency reserves, and in early 2006, its holdings surpassed the $875 billion mark -- pushing it ahead of Japan as managing the world’s largest reserve portfolio. That’s an extraordinary leap. Just two years ago -- May 2004, to be precise --- Japan’s holdings of FX reserves ($817 billion) were fully 78% larger than those of China ($459 billion).

There are several reasons why this state of affairs in not in China’s best interest: First, lacking a well-developed debt market, China has a hard time sterilizing its purchases of dollar-based assets. As a result, excess liquidity leaks into its financial system -- contributing to its bloated money supply and fueling froth in its asset markets, especially coastal property. Second, an educated guess puts the dollar share of China’s reserve portfolio at around 70%, or more than US$600 billion. Dollar depreciation in the 10-20% range would result in a sizable loss in the value of this position -- a distinct negative for China’s overall fiscal position. In this vein, Asian foreign exchange managers are waking up to the need to reassess their portfolio management practices. As Harvard President Lawrence Summers has argued, developing economies have parked a huge share of their some $2 trillion of “excess reserves” in low-yielding dollar-based bonds (see his 24 March 2006 speech, “Reflections on Global Account Imbalances and Emerging Markets Reserve Accumulation”). By forgoing higher returns in alternative investments, poor countries are incurring outsized “opportunity costs” for the sake of keeping their currencies cheap enough to maximize exports to over-extended American consumers. Should the US consumer falter -- an increasingly likely probability -- this strategy will quickly backfire. Of all the developing countries in the world, China -- with its massive build-up of dollar-based foreign exchange reserves -- is most vulnerable to this possibility. Third, there is nothing symbiotic about anti-China protectionism currently working its way through the US Congress. Stable disequilibrium? Don’t bet on it insofar as China is concerned.

The same can be said for the US. Although labor income (private sector compensation) is currently running about $340 billion in real terms below the profile of the typical expansion, the American consumer has pushed consumption up to a record 71% of GDP over the past four years. Property-driven wealth effects more than fill the void. In late 2005, Federal Reserve estimates put equity extraction from residential housing in excess of $640 billion. However, sustainability can be drawn into question on several counts: First, the US housing market has been pushed into bubble territory; in late 2005, fully 55 metropolitan areas were experiencing house price inflation of 20% or higher. With the housing market now rolling over, downside risk to equity extraction and wealth-dependent consumption can hardly be minimized. Second, aggressive equity extraction strategies have pushed household sector debt and debt service to record highs; with much of the newly originated indebtedness taken out at below-market “teaser” rates, the normal reset of lending terms is already pushing up borrowing expenses. Needless to say, a cyclical increase in interest rates -- a development that may now be starting to unfold -- would be all the more disconcerting for overly-indebted US consumers. Third, by replacing income-based saving with asset-dependent saving, consumers have left themselves heavily exposed to shocks; surging oil prices are a case in point -- hitting at a time when consumers’ saving rate is actually slightly negative, rather than the 8% saving rates which prevailed, on average, during the three earlier energy shocks. Chinese funding notwithstanding, the American consumer is hardly in a sustainable disequilibrium either.

If mounting global imbalances are not in China’s or America’s best interests, it is only a matter of time before something pops -- and the sustainable disequilibrium quickly becomes unsustainable. Given the overhang of excess dollar holdings by poor countries, the flight out of dollars could be fast and furious. That could trigger the dreaded dollar-crash scenario and a related spike in real long-term US interest rates. Given the excess consumption and debt overhang in the US, a sharp pullback by the American consumer seems highly likely in such a scenario. This is the disruptive strain of global rebalancing that has long been my biggest fear. The dramatic widening of the US current account deficit to a $900 billion annual rate in the fourth quarter of 2005 -- fully 7% of US GDP -- was a warning shot to take this possibility seriously.

I raised the volume in expressing these concerns in the past few months -- mainly because no one seemed to be listening. A new Federal Reserve chairman took over in the US who dismissed America’s imbalances as an innocent by-product of a “global saving glut.” The financial markets also seemed nonplussed -- especially after the dollar rose in 2005, after having fallen during most of the three previous years. I worried that the world was in denial just when imbalances were nearing the danger zone of maximum vulnerability. But then came the pleasant surprise -- the joint communiqués of the G-7 and IMF on 21 April. Suddenly, the case for global rebalancing was legitimized. No, an instant fix wasn’t offered for an unbalanced global economy, but a framework was proposed that gives the world a much better chance to find a collective resolution of this critical problem. That was not the only development that lowered my discomfort level. Two other central banks jumped on the normalization bandwagon -- the Bank of Japan and the People’s Bank of China -- and the Fed sent a signal that it was more interested in taking its policy rate into the neutral zone rather than into the more painful tightening zone. As a result, the tensions of the global rebalancing framework now stand a much better chance of being resolved in an orderly fashion rather than through a crisis. And so I have changed my assessment of global risks accordingly.

There is, of course, no guarantee this will all work out in the end. I may well be guilty of giving too much credit to the stewards of globalization -- the G-7 and the IMF -- to find a workable solution. It’s one thing to have a framework that allows for shared responsibility in fixing an unbalanced world. It’s another thing altogether for individual nations to do the heavy lifting on economic policies that such responsibilities require. At the same time, the unbalanced world remains highly susceptible to any one of a number of shocks that seem to be lurking in the weeds. High oil prices, Iran, and protectionism continue to worry me the most in that regard.

No, the world has not been healed of all that ails it. But because the powers that be have concluded that imbalances still matter, the urgency of global rebalancing is now center stage in the global policy arena. Call me less of a pessimist, or even an optimist if you wish, but that’s the best news I’ve heard in a long time.