But just because the world’s central banks have financed an expanding US deficit – at least the fraction of the US deficit that private market don't want to finance – up until now is no guarantee that they will finance large US deficits forever. Indeed, rumblings about excessive dollar exposure (and low dollar returns) are growing just as the US economy is slowing. If the Fed started to cut and the dollar lost its interest rate edge over say the euro, the odds are that sustaining the status quo would require more, not less, dollar reserve growth.
The Peterson Institute, Bruegel and the Korean Institute for International Economic Policy recently sponsored a workshop on global adjustment. Alan Ahearne, Bill Cline, Kyung Tae Lee, Yung Chul Park, Jean-Pisani Ferry and John Williamson then joined forces to outline a set of policies that would facilitate global adjustment.
They argue that waiting until the markets “conclude the present situation is unsustainable” to take action to reduce the world's imbalances is risky. I agree, though I might also have said that unless something changes, the real risk is that market pressures will grow to the point where even the most determined central banks give in. The moment central banks stop making up for shortfalls in private flows to the US, watch out.
It is rather hard to come up with a novel list of policy changes to support global adjustment. Adjustment by definition means that US demand growth has to slow relative to income growth (a fancy way of saying the US needs to save more). The most obvious way to increase national savings is to reduce the US fiscal deficit further. Dollar depreciation – additional dollar depreciation – would help support income growth in the US as demand growth slows. And it would certainly help if other countries – particularly China -- took policy steps to support domestic demand growth.
The authors though tried to push the debate forward by trying to put some numbers around the scale of the needed real exchange rate adjustment – think a 10-20% real depreciation in the US and a 10-15% real appreciation in Japan and a 5-25% real appreciation in China. Like most of the IIE, I personally suspect the needed real appreciation in China will be closer to 25% than 5%. As the authors note, to get a small change in the needed real appreciation, you have to assume that Chinese exports are very sensitive to small changes in the value of the RMB. Generating a large real appreciation of the yuan and yen requires quite significant moves in their value against the dollar.
I was lucky enough to have been among those invited to participate in the seminar that preceded the development of this statement, and a couple of things really jumped out at me.
First, most countries (setting the NAFTA countries aside) trade a lot more with each other than with the US. So if everyone lets their currency move against the dollar, the scale of the needed adjustment in other countries real exchange rates needed to generate a big change in the US real exchange isn’t as large as might be expected. If all of Europe appreciates against the US, some European firms will be hurt – but the overall real appreciation is actually rather modest.
Second, most European countries have let the currencies appreciate against the dollar, but only a few Asian countries have. The Korean won hasn’t just appreciated relative to the US. It also has appreciated v. the yen and the Chinese yuan. That really matters. The Koreans are feeling rather lonely right now – they are quite worried by the won’s current strength. If all of Asia appreciated v. the dollar, Asian real exchange rates would move – obviously – by far less than their bilateral exchange rate v. the euro.
My own contribution focused on the role of the oil exporters in global adjustment (alternative link). As I started digging, I discovered -- somewhat to my surprise -- that the pace of adjustment in the big oil exporting economies really seemed to pick up in the course of 2006. Current account surpluses were coming in smaller than initially forecast. It looks like a higher fraction of the 2006 rise in oil revenues was spent on imports – and a smaller fraction was saved – than in 2005 or 2004. Setting Saudi Arabia aside, rising inflation rates also emerged as an important force for real exchange rate adjustment.
Partially as a result of the ensuing low (usually negative) real interest rates, pretty much every oil exporting economy was enjoying a real estate boom. The cranes of Dubai are just the most visible symbol of a far broader process. In 2006, I – with help from Rachel Ziemba and Mikka Pineda – estimated that oil would need to average about $35 a barrel to cover the oil exporters’ broad import bill. In 2007, the oil exporters look set to need oil to average $40 – using the IMF’s oil price – to roughly cover their import bill. That looks rather likely.
I think it is fair to say that there wasn’t a consensus that oil exporters should accelerate the pace of adjustment and embrace a set of policy changes that would push imports up to a break-even price of say $45 a barrel. There is still a bit of uncertainty about the long-run price of oil, among other things.
I also argued that the process of adjustment in the oil exporting emerging economies would be facilitated if they adopted more flexible exchange rate regimes. Exchange rate flexibility would help the oil exporters manage oil price volatility – and the volatility in government revenue that flows from oil price volatility. That applies both on the upswing and on the downswing. Right now, too much of the adjustment to higher oil prices is coming from a rise in inflation and too little from a rise in the currencies of the oil exporters.
Work by the IMF suggests that, historically, a 100% rise in the price of oil leads to a 50% real appreciation, so this process still has further to go. Inflation rates will likely remain high and real rates interest rates low for some time. The overall adjustment will be back-loaded -- much of the increase in domestic absorption will come after oil prices have stabilized or even turned down.
I also argue that dollar pegs have prompted oil-exporting economies to hold more of their savings in dollars than otherwise would be the case, and the availability of dollar financing contributed to a world where almost all of the rise in the global deficit that offset the rise in the oil exporters surplus came from the-importing country with the biggest pre-existing deficit. In my judgment, the process of adjusting to the recent rise in oil prices has been both slower than it should be and too tied to a big expansion of the deficit of a country that already had a big deficit.
I am interested to know what you all think of my argument – as well as what you all think of the broader policy brief.