Unimpressive (the results of the IMF’s experiment with multilateral consultation)
from Follow the Money

Unimpressive (the results of the IMF’s experiment with multilateral consultation)

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Budget, Debt, and Deficits


Macro Man asked the IMF to sort out a world where the US current account deficit is increasingly financed by the growth in emerging market reserves (and the expansion of a few investment funds).     After all, the last few months have seen a marked fall off in the private sector’s willingness to finance the US current account deficit, with the slack taken up by the official sector.  

The Federal Reserve Bank of New York’s custodial holdings are an imperfect measure of official inflows.   They leave a lot out.    But they are currently rising at a $10b a week pace.  The q1 increase, annualized, is close to $510b.    And that just scratches the surface.    Personally I suspect that the dollar holdings of the world’s central banks are growing at a roughly $800b annual pace. 

What happened this weekend?    Best I can tell, not much.  Lots of talk about Paul Wolfowitz, to be sure.  But little else.   

As Stephen Roach highlighted on Friday, the official sector is now inclined to stop fretting about risks associated with the US external deficit and instead to celebrate strong global growth that has accompanied the rise in the US deficit.   

Their timing may prove off.  

The concerns I expressed – along with Dr. Roubini -- about the rising US external deficit back in 2004 were clearly premature.   But after a period when the risks seemed (even to me) to be falling, they look (at least to me) to be rising once again.   US export growth looks to be slowing. Menzie Chinn has all the details.   In 2006, strong export growth helped to offset a rising oil import bill.   I would not count on strong export growth to offset a potentially large rise in the US interest bill during the course of 2007.  

I consequently am less convinced than the G-7 Ministers and Governors (and Iceland's central bank governor) that the US current account deficit has peaked.   And I am quite sure that the share of the US current account deficit financed by the official sector has risen substantially over the past couple of quarters. 

A number of key central banks are finding the current pace of reserve growth - close to $1000b a year -- rather hard to manage, suggesting some risk that they may be forced to adjust their policy framework.    Yet there doesn't seem to be much concern among the leaders of the major economies at this stage, let alone willingness to take coordinated action to to reduce the United States' dependence on central bank financing.

The G-7 communique didn’t say anything new.    The IMF did release something new – a paper outlining the commitments (or perhaps something a bit short of commitments) that emerged from its first multilateral consultation process.    Best that I can tell, they don’t amount to much.  

(More follows - no doubt more than most want to read!)

The policy statement that emerged from the multilateral consultation process seems to be little more than a summary the existing policy priorities of the US, Europe, Japan, China and Saudi Arabia.    Some of the commitments in the paper would actually make the problem worse, not better. Saudi Arabia reiterated its commitment to its dollar peg.  That implies – if the IMF’s analysis of the US dollar is right – further riyal depreciation.    Japan indicated its commitment to fiscal consolidation.    Unless you believe in post-modern economics, that is what deficit countries need to do – not what surplus countries need to do.    It may be right for Japan, but it won’t help reduce the world’s imbalances.   

Europe laid out an agenda for structural reform that is, in my view, peripheral to global adjustment.    But I’ll give Europe a pass.    Europe is doing its part right now.    It has let its currency appreciate.   And it is growing strongly.   The US deficit with Europe is falling fast.    Asia’s surplus with Europe is also rising rapidly --

What of the US?   

Well, the US reiterated its commitment to balancing the budget in 2012, but didn’t indicate how.    Elsewhere – under its commitment to “pro-investment” policies, the US indicated that tax policy is off the table.  A reiterated “commitment to permanently low tax rates” doesn’t suggest much has changed in the US.

The reference to private Social Security accounts (“Social Security reform with Personal Retirement Accounts is again proposed”) also suggest the list of policy commitments isn't worth taking seriously.   Private accounts are a political non-starter for one.  And I am pretty sure that reducing the gap between what Social Security takes in and what it pays out after 2040 won’t do much to reduce the United States current dependence on Chinese financing.  Indeed, if the US borrows more money to finance the transition costs – the new private accounts have to be funded out of money that goes to pay current benefits, and unless current benefits are cut, there is a problem – it might widen imbalances not shrink them.   The large surplus in the social security system is currently helping to hold the fiscal deficit down. 

The US also indicated its desire to keep US capital markets competitive.   Fair enough.  But the financial competitiveness agenda – basically, the battle over IPO fees --  has a lot bigger impact on the imbalance between the bonuses paid by Goldman London and Goldman New York (and perhaps in the future the imbalance between bonuses in Goldman Shanghai and Goldman New York) than on global imbalances.     Long-term, I also suspect that it will be hard to convince the world to raise money in the financial center of a country with no household savings.   Any money raised in the US is effectively money borrowed from somewhere else.

Indeed, global adjustment requires that the US financial markets become a bit less competitive – or at least a bit less attractive – to foreign capital.  Without the ability to borrow savings from the rest of the world, the US would have to adjust.    That has happened to a degree.   Net private flows have fallen off recently.     But the PBoC, the Bank of Russia, the Reserve Bank of India and the Banco Central do Brazil made up the difference.   The BRICs added $200b to their reserves in the first quarter – providing $150b of financing to the US.   No doubt the Saudis, the Kuwaitis and Abu Dhabi chipped in as well.     

What of China?    Well, they reiterated their existing exchange rate policy “The exchange rate formation mechanism will be improved in a gradual and controllable manner. Exchange rate flexibility will gradually increase.”   So far “gradual and controlled” has meant that the RMB has appreciated just fast enough against the dollar to offset the dollar’s slide v. other currencies.    That won’t cut it.   China needs to appreciate against a basket of currencies, not just against the slumping dollar.    Otherwise its real exchange rate won’t rise.

China’s other policy commitments haven’t been sufficient to reorient its economy away from export-led growth.  Net exports have contributed over 2% to Chinese growth over the past couple of years.   And as the IMF’s (exceptionally good) Asian regional outlook makes clear, the rest of Asia relied heavily on exports for growth over the past couple of years – often more heavily than China, since the domestic components of growth are weaker elsewhere.   Asia’s current account surplus rose by 1% of its GDP in 2006 – even as its oil import bill soared.  

The recent data suggests a strong pick up in Chinese exports at a time when US export seems to be slowing.   That implies that China’s already large (9% of GDP) current account surplus will get even bigger.   No rebalancing there.   

More of the same won’t work – the “same” is a growing Chinese current account surplus and exceptionally rapid Chinese reserve growth.  Some in China know this.  There just isn’t consensus to do enough to change the dynamic. 

China also highlighted the progress it has made reforming its financial sector – and its commitment to do more.     The progress here is real.   The balance sheet of the 3 of the 4 state banks have been cleaned up.    They have gotten a new injection of equity capital from the state – and raised additional funds from the private markets.

But progress here hasn’t helped reduce China’s current account surplus.   Recapitalizaing the financial sector without changing the exchange rate hasn’t worked.      And I am not convinced that further financial sector reforms are the key to reducing China’s surplus.  

Let me reframe that:  there is one financial reform that I am pretty sure would work: dropping the existing curbs on lending, and letting the banks lend out all their spare liquidity.    That no doubt would mean financing lots of inefficient investment and would lead to future bad loans that would require a new round of bank bailouts.   But in the interim, more lending would mean even more investment, even faster growth, rising inflation, real appreciation, stronger imports and less pressure for the current account surplus to rise.

But I am not sure that reforms to improve the efficiency of the financial sector would necessarily reduce imbalances.    A more efficient financial sector might allow China to achieve the same level of growth with less total investment.   But unless savings also falls, that means a bigger, not a smaller, gap between savings and investment – and a bigger current account surplus. 

The other argument is that a more modern financial system would provide more financing to Chinese households and less financing to Chinese enterprises.   In this view, the development of the financial system will necessary lead to a rise in consumption, as China’s financial system will start to look more like the United States’ financial system (breaking views expressed this view in their April 2 comment on ICBC, for example).   In the US, remember, households don’t save as much as they invest in residential construction – so the financial system effectively raises money abroad to finance the household’s sector’s deficit.  

Over time, that may happen in China too.   Though I rather suspect that China is still at the stage of development where it makes sense for household savings to finance business investment, not at the stage where business savings finances household consumption.   But my understanding is that the banks’ experiments with credit cards in China haven’t worked that well – Chinese households save, remember, so they don’t need to borrow.   If everyone pays off their credit card at the end of the month, the banks don’t make money. 

And their may be a more fundamental problem.   Chinese bank lending is currently capped by administrative diktat.  More lending to households implies less lending to firms.    More household lending and consumption might trade off with less business lending and less business investment.    Yet to reduce its surplus, China has to both consume and investment more – not just consume more and invest less.

It consequently seems to me that measures that directly reduce savings – SOE dividend payments, government borrowing to finance a big surge in social spending and social insurance and so on – are more likely to produce results that financial sector reform.

Moreover, it seems to me that the biggest constraint on financial sector reform is the weak exchange rate.    It is the exchange rate that forces China to keep interest rates low.   And the need to keep the economy from overheating when exports are contributing so strongly to growth has led to heavy reliance on administrative caps on bank lending.  

Others -- Eswar Prasad for example -- believes financial sector reform is more important than I do.   But Prasad also emphasize the constraints China’s existing exchange rate regime places on financial reform.   Financial reform isn’t a substitute for RMB appreciation.

No matter.   I didn’t see anything in China’s list of commitments that suggests that China will do something fundamentally different than what it has been doing.   

There isn’t broad intellectual consensus on the role exchange rates play in the adjustment process.   Asian economies – along with some prominent academics – think they don’t matter much.   Or at least Asian economies argue that they don’t matter, and that the focus has to be on more fundamental factors that drive savings and investment (as David Altig notes,China is resisting efforts to firm up IMF exchange rate surveillance).   That though opens up the process to cover a huge range of policies that can be argued to influence (weakly) savings and investment rates.  It lends itself to laundry lists.

Moreover, it is pretty clear that if China decides to allow a bit more appreciation – or if the Saudis ever recognize that their dollar peg isn’t serving their interests—they won’t announce the policy change in something that looks like a IMF communiqué.

My guess is that the IMF wanted to bring the multilateral consultation process to a close – and consequently was willing to accept a laundry list of national commitments no matter how or how little they actually would do to reduce the world’s imbalances.

The IMF’s first deputy managing director, John Lipsky, clearly thinks the risks associated with imbalances have been overstated and the gains from the strong growth generated by an unbalanced world have been downplayed (see this article, based on Chris Giles' interview with Lipsky, and the introduction to this Lipsky speech).    He wants the IMF to focus less on the risks associated with the current process of globalization – one driven by the uphill flow of official capital – and more on the opportunities the current process of globalization has generated.  

The IMF’s Manading Director, Rodrigo de Rato, I suspect, realized that multilateral consultation wasn’t going any where and needed an out.  But he hasn’t been as transparent in his thinking as Dr. Lipsky.

I am also not convinced that Hank Paulson worries all that much about imbalances either.   Treasury Under Secretary Tim Adams did worry, but he is on his way out.  Paulson seems far more driven by the need to improve the United States'“financial competitiveness” and opening China’s financial sector and capital markets to foreign  financial firms than by imbalances.   But I think he also realizes that a deal that leaves China’s exchange rate unchanged but allows more foreign investment in Chinese banks won’t do much to address the concerns of the median worker – or the concerns of most of the US Congress.   US auto parts workers don’t get much of their income from dividends on Goldman stock.

The locus for a deal, if there is one, won’t be the IMF.  It will be Paulson’s Strategic Economic Dialogue with China.     That makes a certain amount of sense.   China alone probably will finance about ½ the US deficit this year.   And the slow pace of RMB appreciation constrains the amount of appreciation that is politically acceptable elsewhere.    As oil spending picks up and the oil surplus recedes and as China’s share of Asia’s surplus rises, the number of countries who need to be in the room shrinks. 

Actually, it isn’t obvious to me that the Strategic Economic Dialogue will be the locus of a deal.   I suspect the real action is inside China.   The Chinese have to determine if they are happy with a system that requires that they provide an ever rising amount of financing – up to $400b this year – to the US.   If China's leaders ever decide they want to change this system unilaterally, they can.

p.s.   The multilateral consultation process did have one important side effect: it generated a real improvement in the IMF’s analytical capability.   The IMF staff has improved its methodology for assessing real exchange rates – though it isn’t allowed to publish the results.    The chapter in the WEO on the role of exchange rate adjustment in external adjustment is quite good.    Real depreciations are a common feature of expansionary adjustments.   And if you previously thought that reducing the US trade deficit by 5% of GDP (to1% of GDP) would take a 50% depreciation in the dollar, it offers hope that a smaller adjustment might suffice.     The regional outlook on Asia – with its focus on capital flows in and out of Asia – is also superb.   Too bad the policy commitments that emerged from the multilateral consultation process didn’t measure up to the analysis that went into it.

More on:

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Budget, Debt, and Deficits