Global rebalancing

Financial Express, 30 November 2007

Major developments are underway in the world economy. The long-awaited `global rebalancing' is, finally, underway. As expected, this has created a number of difficulties in the US economy. The US is likely to have below-trend growth in both 2007 and 2008. It is very likely that the US Fed will cut rates, but this could well accentuate US inflation, creating a stagflationary environment. The US slowdown will, no doubt, exert a drag on the world economy, including India. With the US adjustment having commenced, the key question is now about what will happen in China.

For many years, economists warned the world about the difficulties of `global imbalances'. This comprised of many elements, the main ones among which were: a large US fiscal deficit, a large US current account deficit, a housing bubble in the US, massive reserves accumulation in Asia, an overvalued dollar, a distorted exchange rate in China, and an investment bubble in China. Economists like Martin Feldstein and Ken Rogoff diagnosed deep connections between these apparently unrelated phenomena. For many years, financial markets largely ignored the economists, thinking that business could go on despite these difficulties, while the economists continued to warn that things that can't go on, don't. In 2007, it is clear that an unwinding of global imbalances has begun.

Many signs now suggest that the long-awaited `global rebalancing', which corrects these several pathologies, is underway. The US has been putting its fiscal house in order, pulling back from a deficit of 3.6% in calendar 2004 to 1.2% in 2007 - an improvement of 2.4% in three years. The US dollar has crashed dramatically - the `Major Currencies Index' of the US Fed has dropped by roughly 40% in five years. There has been a sharp collapse in the US housing market. In response to these three developments, the US current account deficit has started to shrink.

These developments, of course, imply substantial difficulties in the US economy. Fiscal consolidation is contractionary. The difficulties in US housing have adversely affected the spending of many households. At the same time, the drop in the US dollar have spurred demand for US exports and has helped to prop up the economy. Present projections suggest that the US is likely to have just 2% GDP growth in both 2007 and 2008. This is below the trend US growth rate of 3%. Projections for 2009 are also below 3%.

Under these conditions, it is now very likely that the US Fed will cut rates. However, the headroom for this is limited, given stubborn inflation in the US, that is partly accentuated by the dollar depreciation. If the US Fed gives in to political pressure, and cuts rates while inflation is worrisome, this could give the worst of all worlds - a stagflation - where a recession and inflation go together. The events of 2007 have demonstrated the difference with the UK and European monetary policy framework, something that Alan Greenspan pointed out in his recent book, where inflation targeting is written into law and the central bank has its hands tied down - when compared with the US framework, where the US Fed has discretion on how seriously to focus on inflation, and thus comes under political pressure to allow higher inflation.

The US slowdown will exert a drag on the world economy, including India. While a drop in US imports and a rise in US exports is good for the US economy, and helps compensate for the fiscal consolidation coupled with housing bust, it is only bad news for the world economy. The slowing US economy is the deeper story about the weakening of economic conditions worldwide.

There have been arguments about Asian decoupling, and how the world economy will absorb a US slowdown because China and India are growing well. However, the numbers do not square with this optimistic assessment. China and India are too small to affect the world economy as of yet. And a US slowdown will adversely affect exports from both China and India. This will have an indirect effect on other Asian countries who are supply raw materials to firms in China and India who go on to export goods and services into the US.

With the US adjustment having commenced, the key question is now about what will happen in China. So far, there has been no progress on the resolution of the macroeconomic imbalances in China. China continues to pursue a faulty exchange rate regime; the Chinese Yuan is undervalued and is a one-way bet that is attracting massive capital inflows through both legal and illegal means. House prices, stock prices, food prices are all showing very high inflation. Reserves continue to grow at a pace of $25 billion a month or worse. The Chinese government lacks the tools of macroeconomic policy - such as monetary policy - to influence the economy. In a world that is successfully rebalancing, China stands out as a big risk. With falling levels of the consumption ratio, high levels of savings and investment especially by Public Sector Enterprises and a 12 percent current account surplus it remains to be seen what role China plays in the global rebalancing under way.

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