Transcript Slide

G20 Guidelines
for Persistently Large Imbalances
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
Experts Panel
G20 Working Group
on the Framework for Strong, Sustainable and Balanced Growth
Paris, 13 January, 2011
Imbalance Preliminaries

First, we must reject the mercantilist view
that trade deficits are always necessarily bad

Sometimes deficits make sense,

e.g., for a country that has just discovered oil.
2
An example of
intertemporal
optimization
in practice:
When Norway discovered
North Sea oil in 1970s,
it temporarily ran a
large CA deficit,
•
to finance investment
(while the oil fields were
being developed)
•
& consumption
(as was rational,
since Norwegians knew
they would be richer
in the future).
Subsequently, Norway
ran big CA surpluses.
3
Preliminaries,

continued
Second, we must equally reject the view that
current account deficits always necessarily
represent intertemporal optimization
A developing country that runs a persistent large
deficit risks an eventual crisis,
 due to financial market imperfections

default risk, moral hazard, distorted incentives,
 procyclical fiscal policy, procyclical capital flows…

4
In my judgment, it would indeed be useful if a
current account deficit or surplus of 4% of GDP
triggered a G-20 process to consider if the
“imbalance” was a problem and, if so, what
combination of policy responses is appropriate.
5

Example: the combination of a big US CA deficit
and big Chinese CA surplus could result in a G-20
agreement that the US national saving rate and
Chinese exchange rate are both part of the problem,
and both require gradual but genuine adjustment.
• It would be better than some alternatives:
• hard landing for the $ and new crisis;
•US Congress passes WTO-illegal trade sanctions
• as punishment for Chinese “currency manipulation”;
• or China accuses US of QE2 “currency war.”
6
Can the academic literature
shed light on indicator variables?

10 years ago, economic research focused on
two entirely distinct international financial
problems:
 (I)
Crises in emerging markets
 (II) G-7 current account imbalances.

Historic convergence:
a
decade later, the two worlds overlap.
7

Today, major emerging markets:
are in the G-20,
 float,
 run current account surpluses, and
 have lower debt than advanced economies.



Debt/GDP of the top 20 rich countries (≈ 80%) is
twice that of the top 20 emerging markets, and growing.
Some EMs
have better credit ratings than some advanced economies,
 have learned how to follow countercyclical fiscal policy



while the US, UK, and much of Europe have forgotten how to, and
were better able to weather the 2008-09 global recession.
8
(I) What did we learn
from the empirical literature
on emerging market crises?


Frankel & Saravelos (2010) survey 83 contributions
in the pre-2009 Early Warning Indicators literature.
The indicators found useful most often, by far:




Foreign exchange reserves (e.g., relative to debt)
Real exchange rate (e.g., relative to historic PPP).
These were also the two indicators most often
statistically significant in predicting, across 5 measures,
how hard countries were hit by the 2008-09 global crisis.
Also useful: current account and national saving / GDP.
9
EWIs: The variables that show up as the strongest
predictors of country crises in 83 studies are:
(i) reserves and (ii) currency overvaluation
0%
10%
20%
30%
40%
50%
60%
70%
Reserves
Real Exchange Rate
GDP
Credit
Current Account
Money Supply
Budget Balance
Exports or Imports
Inflation
Equity Returns
Real Interest Rate
Debt Profile
Terms of Trade
Political/Legal
Contagion
Capital Account
External Debt
% of studies where leading indicator was found to be
statistically signficant
(total studies = 83, covering 1950s-2009)
Source: Frankel & Saravelos (2010)
10
Best and Worst Performing Countries -- F&S (2010), Appendix 4
GDP Change, Q2 2008 to Q2 2009
Lithuania
Latvia
Ukraine
Estonia
Macao, China
Russian Federation
Bottom 10
Georgia
Mexico
Finland
Turkey
Australia
Poland
Argentina
Sri Lanka
Jordan
Indonesia
To p 10
Egypt, Arab Rep.
Morocco
64 countries in sample
India
China
-25%
-20%
-15%
-10%
-5%
0%
5%
10%
11
Table Appendix 7
Coefficients of Regressions of Crisis Indicators on Each Independent Variable and GDP per Capita* (t-stat in parentheses)
bolded number indicates statistical signficance at 10% level or lower
F & Saravelos
(2010):
Multivariate
Exchange
Market
Pressure
Currency % Recourse to
Changes
IMF
(H208-H109
(SBA only)
Equity
%Chng
(Sep08Mar09)
Equity %
Chng
(H208H109)
S ignif ic a nt
a nd
C o ns is t e nt
S ign?^
Independent Variable
R
E
S
E
R
V
E
S
R
E
E
R
G
D
P
C
R
E
D
I
T
C
U
R
R
E
N
T
A
C
C
O
U
N
T
Reserves (% GDP)
0.164
(3.63)
0.087
(2.98)
-1.069
(-1.66)
0.011
(0.12)
0.010
(0.14)
Yes
Reserves (% external debt)
0.000
(1.06)
0.000
(1.1)
-0.006
(-2.29)
0.000
(1.81)
0.000
(2.65)
Yes
Reserves (in months of imports)
0.004
(2.25)
0.003
(1.95)
-0.119
(-3.01)
0.006
(1.32)
0.009
(2.32)
Yes
M2 to Reserves
0.000
(0.27)
0.000
(0.76)
-0.044
(-0.91)
0.000
(0.02)
-0.000
(-0.09)
Short-term Debt (% of reserves)
-0.000
(-1.97)
-0.000
(-4.22)
0.000
(2.13)
-0.001
(-2.89)
-0.001
(-3.11)
Yes
REER (5-yr % rise)
-0.440
(-5.55)
-0.210
(-3.19)
1.728
(2.15)
-0.182
(-1.24)
-0.185
(-1.61)
Yes
REER (Dev. from 10-yr av)
-0.475
(-3.96)
-0.230
(-2.47)
2.654
(2.56)
-0.316
(-1.71)
-0.316
(-2.1)
Yes
GDP growth (2007, %)
-0.000
(-0.2)
0.001
(0.94)
0.070
(2.58)
-0.001
(-0.1)
-0.007
(-0.71)
GDP Growth (last 5 yrs)
-0.003
(-0.81)
0.000
(0.26)
0.084
(2.4)
-0.003
(-0.26)
-0.014
(-1.15)
GDP Growth (last 10 yrs)
0.000
(0.14)
0.001
(0.43)
0.064
(1.66)
-0.012
(-0.67)
-0.020
(-1.12)
Change in Credit (5-yr rise, % GDP)
-0.021
(-0.36)
-0.035
(-0.98)
0.552
(1.02)
-0.274
(-2.97)
-0.248
(-4.13)
Change in Credit (10-yr rise, % GDP)
-0.017
(-0.93)
-0.011
(-1.05)
0.210
(1.03)
-0.089
(-1.65)
-0.089
(-2.35)
Credit Depth of Information Index (higher=more)
-0.008
(-1.06)
0.000
(0.05)
0.224
(2.4)
-0.006
(-0.37)
-0.018
(-1.33)
Bank liquid reserves to bank assets ratio (%)
0.000
(3.84)
0.000
(0.5)
-0.000
(-11.44)
-0.002
(-0.54)
-0.002
(-0.79)
Yes
Current Account (% GDP)
0.001
(1.48)
0.002
(2.7)
-0.023
(-2.09)
0.009
(3.84)
0.007
(3.95)
Yes
Current Account, 5-yr Average (% GDP)
0.000
(0.48)
0.001
(1.82)
-0.025
(-1.72)
0.007
(2.4)
0.006
(2.74)
Yes
Current Account, 10-yr Average (% GDP)
0.000
(0.14)
0.002
(1.39)
-0.035
(-2.11)
0.008
(2.21)
0.007
(2.44)
Yes
Net National Savings (% GNI)
0.002
(1.6)
0.001
(2.33)
-0.013
(-1.22)
0.006
(2.92)
0.004
(2.28)
0.003
(2.01)
0.001
(2.53)
-0.015
(-1.36)
0.008
(3.42)
0.006
(3.03)
Gross National Savings (% GDP)
Yes
Yes
12
Yes
(II) What did we learn
from the literature on
G-7 current account imbalances?
13
Economists were split between
those who saw the US deficit as
unsustainable, requiring a $ fall,








Ken Rogoff *
Maury Obstfeld
Larry Summers
Martin Feldstein
Nouriel Roubini
Menzie Chinn
Me
Lots more
& those who saw the US
as providing a service.








Ricardo Caballero *
Richard Cooper
Ben Bernanke
Michael Dooley
Pierre-O. Gourinchas
Alan Greenspan
Ricardo Hausmann
Lots more
14
* Some claim that the financial crisis of 2007-09 fit their theories.
Were current account imbalances
the cause of the financial crisis, as many say?

Those of us who predicted an unsustainable
US current account deficit and a $ hard landing
were proven wrong by the 2008 movement into $.

Meanwhile, those who said the US CA deficit was
sustainable because of the superior quality of US
assets were also proven wrong.
corporate governance,
 accounting system,
 securities markets, rating agencies…

15
MSN Money & Forbes
Were current account imbalances
the cause of the financial crisis? continued

Not in my view. The financial excesses of 2001-2007
would have been pretty much the same even if each
country’s inflows & outflows had netted out.

The US ran current account deficits (financed by foreign
official $ purchases) as a side effect of excess liquidity
and overspending, not primarily as a cause.


In net terms, private foreigners financed less of the US CA
deficit than foreign central banks after 2003.
The story is in the gross volume of financial transactions,

not in net cross-border flows.
16
7 challenges to “twin deficits” view
•
•
•
•
•
•
•
US investment climate
Global savings glut
“It’s a big world”
Valuation effects will pay for it
US as the World’s Banker
“Dark Matter”
Bretton Woods II
17
Conclusion regarding
sustainability of the imbalances:


The 7 arguments are clever,
but I am not convinced.

Some of these arguments rely on $ retaining its
unique role in world monetary system forever.

But the US may not be able to rely
on exorbitant privilege forever.
18
Conclusions
for the G-20/IMF Mutual Assessment Process


Regardless whether one thinks that big current
account imbalances caused the global financial
crisis, 2007-09, they could cause the next crisis.
G20 is the forum to consider the controversies.


with the IMF supplying the numbers
 As in G20 Mutual Assessment Process, IMF, Nov. 2010
at://www.imf.org/external/np/g20/pdf/111210.pdf .
A good G-20 result would be shared recognition
that China’s currency and America’s budget
deficit should both gradually adjust.
19
Useful indicators for the G20 MAP
Short list:

Budget deficit & national saving /GDP.

Current account /GDP.

Not bilateral trade balances,

which are not economically relevant,
 even though the US Treasury biannual reports use them:
as shown statistically in Frankel & Wei (2007)
"Assessing China's Exchange Rate Regime," Economic Policy.

Real exchange rate.
relative to the country’s long-run history
 and also relative to the long-run equilibrium rate
predicted by the Balassa-Samuelson relationship.

20
When the concern is global aggregate
demand, rather than imbalances

The locomotive theory:

In times of global recession,
the concern is that each country holds back expansion
of demand (esp. fiscal) unless it is done cooperatively.

Examples: 1978 Bonn Summit & 2009 London Summit

There may also be times when the concern
is that each country will expand too much,
unless they can agree on cooperative discipline.

Then indicators of demand are needed.
21
For the longer term, the G20 may want to
focus on a broader list of economic variables

Precedent: The Tokyo Summit of May 1986 decided
that G-7 Finance Ministers of the G-5 countries,
would focus on a set of 10 “objective indicators.”



No pretense was made that the members would rigidly commit
to specific numbers, in the sense that sanctions would be imposed
on a country if it deviated far from the values agreed upon.
But the plan did include the understanding that "appropriate
remedial measures" would be taken whenever there developed
significant deviations from the “intended course.”
Like Truman’s recent “Strengthening IMF Surveillance” proposal

Policy Brief 10-29, PIIE, Dec. 2010.
At http://www.iie.com/publications/interstitial.cfm?ResearchID=1730
22
The list of 10 “objective indicators”
chosen by the G-5 in 1990:

4 “locomotive” oriented indicators:
 growth

rate, inflation, unemployment, money;
3 “imbalance” oriented indicators:
 fiscal
deficit/GNP,
 current account & trade balances;

3 “currency war” oriented indicators:
 reserve
holdings, exchange rate, and interest rate.
23

Proposal:
Cut down the list of objective indicators
 by focusing on nominal GDP



Nominal GDP is a “sufficient statistic”
for each country’s contribution to aggregate demand


or, better yet, nominal demand.
allowing deletion of: real growth, inflation, unemployment, money.
Reference:


Frankel, "International Nominal Targeting (INT): A Proposal for
Monetary Policy Coordination in the 1990s,"
The World Economy, 13, no. 2 (June 1990), 263-273.
At http://www.hks.harvard.edu/fs/jfrankel/MONTDUMM.R51.PDF
24
Appendix:
Seven Clever Reasons We Have Been Told
Why We Are Not Supposed to Worry
About the US Twin Deficits
[i]
[i] But I don’t believe them: Frankel, “Nine Reasons We Are Given Not to Worry About the US Deficits,”
Commission on Growth & Development. At http://ksghome.harvard.edu/~jfrankel/GrowthCommssnReasonsWorryDeficits.pdf25
1. Capital flows to US due to favorable
investment climate & high return to capital .
 But
Even before the slowdown, US business Investment
< in 90s IT boom (or 60s, 70s, & 80s).
 FDI has flowed out of the US not in.
 The money coming into US is largely purchases of
short-term portfolio assets,
esp. acquisition of $ forex reserves.

26
2. “The problem is a global savings glut,
not a US saving shortfall.”
[1]

True, foreign net lending to US is determined
by conditions among foreign lenders as much as in US.

But “savings glut” misleading: Global saving is not up. [2]

Rather, global investment is down (even before 2008 slowdown).

This pattern is inconsistent with the hypothesis that
the exogenous change is an increase in saving abroad:
that would have shown up as a rise in investment.

The pattern is consistent, rather, with the hypothesis that
the US shortfall is sucking in capital from rest of world.
____________________________
[1]
Bernanke (2005).
[2]
Japan’s household saving rate = 7% of disposable income, vs. 23% in 1975.
27
3. “It’s a big world.”

Alan Greenspan, Richard Cooper, & others:

world financial markets are big, relative even to $3 trillion
of US net foreign debt, and increasingly integrated.

=> Foreign investors can bail the US out for decades.

Foreign investors moving, even slowly, toward fully
diversified international portfolios (away from “home
country bias”), can absorb US current account deficits
for a long time.

True. But , for assessing default or country risk,
global wealth may not be the relevant denominator.
28
If the US were any other country…

The proper denominator of US debt would be
not the size of the world portfolio, but
 US ability to pay

Measured by US GDP, or
 by US exports or tradable goods production


which is unfortunate, in light of low US X/GDP ratio
-- Obstfeld & Rogoff (2001, 2005).

US Debt/export path may be probably explosive.
29
4. US CA deficit need not imply rising debt
& debt-service, due to valuation effects

Lane & Milesi-Feretti (2005…) compute valuation effects.

Gains in $ value of assets held abroad,
particularly via $ depreciation,
have largely offset increased quantity of liabilities
=> US net debt has risen “only” to $2 ½ trillion,
despite much larger increase in liabilities to foreigners.


But how many
times can the US
fool foreign investors?
30
5. US as World’s Banker

Despite years of deficits,
net investment income remained in surplus. Why?

US earns higher rate of return on its assets abroad (especially
FDI) than it pays on its obligations (especially T bills),
because US has assets of uniquely superior quality .






Kindleberger (1960s):
US is World Banker, taking short-term deposits & investing long-term.
Gourinchas & Rey (2005):
US is global “venture capitalist.”
Caballero, Farhi & Gourinchas (2007):
“Intermediation rents…pay for the trade deficits.”
Forbes (2008): Money flows to US from places less-developed financially
31
Also theories by Mendoza, Quadrini & Rios-Rull (2006), Wei & Wu, and others
6. Dark Matter

“That US Net Investment Income
is still in surplus implies missing assets.”

Hausmann & Sturzenegger (2006) called hidden US assets
(know-how) that are not properly reflected
in service export numbers “dark matter.”

The argument probably overemphasizes the reliability
of investment income data (relative to service export data)



Kozlow (2006): Dark Matter based on faulty interpretation of the data
Curcuru, Dvorak, & Warnock (2007) :
US capital gains on foreign securities are overstated,
and so US international investment income is too.
Daniel Gros (2006): foreign companies understate profits of US subsidiaries,
32
to avoid taxes; again net US income overstated.
32
7. Bretton Woods II: “China’s development strategy
entails accumulating unlimited dollars.”

Deutschebank view (Dooley, Folkerts-Landau, & Garber, 2005…):

Today’s system is a new Bretton Woods, with Asia
playing role that Europe played in 1960s.

That much is right.

DFL ideas were original:


China piles up $
not because of myopic mercantilism,
but as part of an export-led development strategy
that is rational given China’s need to import
workable systems of finance & corporate governance.
33
But it is not sustainable.

It may be a Bretton Woods system,
but we are closer to 1971 (date of collapse)


than to 1944 (date of BW agreement)
or 1958 (when convertibility was first restored).
(1) Capital mobility is much higher now than in 1960s.
(2) The US can no longer necessarily rely on support of foreign
central banks, either economically or politically.
(3) The theory that China imports a world-class system of finance
& corporate governance from the U.S. no longer looks so good.
34
“Dollar holders won’t sell because they
would be only hurting themselves”



This factor was the same in 1973.
In fact the governments holding $ then had an
agreement not to sell (which is not true today).
When the time comes, each central bank will be
afraid that if it is the only one that doesn’t move out
of $, everyone else will anyway, driving the dollar
down, and leaving it “holding the bag.”
Just as in any speculative attack.
35
36