House of Paine

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BLITHERATION 



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" excessive dependence of global growth
 on unsustainable processes 
in the United States and to a lesser extent in China"

" the elevated level of asset prices
 particularly housing, 
and the high and volatile price of oil
 The downside risks to our forecast
 are thus considerable " 

"these varied concerns come together 
in the growing global imbalances" 







 The United States is running a current account deficit 
approaching 6 1/4 percent of its GDP this year
 and over 1.5 percent of world GDP
 And to finance it
 the United States needs to pull in 70 percent
 of all global capital flows

 While the deficit is still increasing
 the location of the surplus countries
 is changing
 The current account surpluses 
of the oil-exporting countries
 of the Middle East
 have now surpassed 
those of emerging Asia
 which were already quite high" 



Unlike those who view the imbalances 
as mirroring a savings glut
 I see the problem as the world 
is investing too little.

the current situation has its roots 
in a series of crises 
over the last decade 
that were caused by excessive investment
 such as the Japanese asset bubble
 the crises in Emerging Asia and Latin America
 and most recently
 the IT bubble
 Investment has fallen off sharply since
 with only very cautious recovery.



This is particularly true 
of emerging Asia and Japan.

The policy response 
to the slowdown in investment
 has differed across countries

 In the industrial countries
 accommodative policies
 such as expansionary budgets
 and low interest rates
 have led to consumption- or credit-fuelled growth
 particularly in Anglo-Saxon countries. 

Government savings have fallen
 especially in the U.S. and Japan
 and household savings have virtually disappeared
 in some countries with housing booms 

By contrast
 the crises were a wake-up call
 in a number of emerging market countries
 Historically lax policies have been tightened
 with some countries running primary fiscal surpluses
 for the first time
 and most bringing down inflation 
through tight monetary policy. 


With corporations cautious about investing 
and governments prudent about expenditure
-especially given 
the grandiose projects 
of the past-

exports have led growth 
and savings have built up
 Many emerging markets 
have run current account surpluses 
for the first time
 In emerging Asia
 a corollary has been
 to build up international reserves 


Some call this a new world order
 I see the situation as a temporary 
but effective response to crisis

 It is somewhat misleading 
to term this situation 
a "savings glut" 
for that would imply 
that countries running current account surpluses 
should reduce domestic incentives to save
 But if the true problem is investment restraint
 then a reduction in world savings incentives
 will engender excessively high real interest rates 
when the factors holding back investment dissipate
 The world now needs two kinds of transitions


First, consumption has to give way 
smoothly to investment
 as past excess capacity 
is worked off 
and as expansionary policies 
in industrial countries return to normal
 Second, to reduce the current account imbalances 
that have built up
 demand has to shift 
from countries running deficits 
to countries running surpluses 

There are reasons to worry 
whether the needed transitions
 will take place smoothly

 First, we need more investment
 especially in low-income countries
 emerging markets, and oil producers
 China is an exception in needing less
 not more, investment

 The easy way to get more investment 
is a low-quality investment binge
 led by the government
 or fuelled by easy credit
-emerging market countries
 are only too well aware 
of the pitfall of that approach
 The harder, and correct,
 way is through 
product, labor, and especially
 financial market reforms
 which will ensure 
that high-quality investment emerges

 However, and somewhat paradoxically,
 the emphasis that some governments
 have placed on strong exports 
and sound monetary and fiscal policies
 may have caused them to neglect 
the structural reforms 
that would have strengthened investment 
and helped sustain domestic demand
 As a result, 
these countries are overly dependent 
on demand from other countries 


Moreover, the absence of such reforms
 limits the rate of return on investment 
in those countries and prevents
 capital flowing from aging rich countries
 to younger developing countries.
 This must change.

Second, easy financial conditions 
and trade may have allowed economies
 more rope so that traditional signals
 like inflation, interest rates,
 and exchange rates 
have not guided transitions thus far

 But while more rope allows one 
to drift further
 adjustments when one reaches the end
 of the tether tend to be abrupt

 Perhaps the central concern 
has to be about consumption growth
 in the United States
 which has been holding up the world economy

 Higher energy prices in the United States
 could eat into disposable incomes 
and consumer confidence
 leading to an abrupt fall in consumption

 Another risk is that the higher energy prices
 start to feed more permanently into inflation 
and inflationary expectations
 which have remained well anchored so far
 causing the Fed to tighten
 either faster or further " 

"This would have several negative effects
 First, it could mean higher interest payments
 for households, reducing available income for consumption
 Second, more broadly
 it could put a lid on house price growth
 For several years now
 the wealth gains for increased home equity
 have been a strong support 
to consumer spending
 Lastly, it could hinder investment 
just when it should be taking over
 as the source of growth from consumption
 Thus my greatest worry is not
 that U.S consumption will slow-it
 has to because it is being fuelled by 
unsustainable forces
 My worry is that it will slow abruptly,
 taking away a major support from 
world growth before 
other supports are in place.

A second concern has to be about
 the financing of the U.S. current account deficit
 If it narrows slowly
 will foreign investors continue
 to buy U.S. assets 
without hiccups for the time it takes 
for the real side to adjust? 




Let us look at the composition of capital flows 
into the United States for some clues to the answer
 Overall, the bulk of U.S. assets
 sold to foreigners
 are still to the private sector
 This may come as a surprise
 to some of you who believe 
that the U.S. current account deficit 
is being financed by foreign central banks
 The reality is that
 while the foreign official sector
 has increased its purchases
 it still only amounts to less than
 one-third of the total inflows
 into the United States

 So where is the rest going 
if, as was the case till recently,
 foreign central banks 
were putting in enough 
to nearly match the deficit? 

The answer is that it comes out again
 as U.S. investors buy foreign assets



It is therefore entirely correct
 to say the U.S. current account deficit
 is more than fully financed 
by foreign private investors 
while U.S. private investment abroad 
is partly financed by foreign central bank investment 
in the U.S.
 From the evidence we have so far
 foreign central banks 
do not appear to vary their purchases 
of U.S. Treasuries 
in a systematic way with changes 
in the trade-weighted dollar
 Profits are less important
 to central banks
 and they are less likely to make
 a rapid shift in the composition
 of their reserve portfolio
 - though given their size, 
they have the ability to roil markets 
if they do, or if politicians hint they will
 But before central banks turn decisively
 foreign private investors
 who have no motive to buy dollars
 other than returns will have fled
 It is they who are key 
to the financing of the U.S. 
current account deficit.




Given this, it is worth noting 
that both foreign direct investment 
and net purchases of equities
 by non-residents 
have declined markedly since 2000
 Foreign direct investment 
has staged a partial recovery since then
 but remains below 1 percent of U.S. GDP
 The decline coincides with a drop off 
in M&A activity 
in the United States 
and overleveraged balance sheets 
in the Euro area and Japan
 At the same time
 net purchases of fixed income securities
 have increased substantially

 with most of the increase consisting 
of Treasuries.

 On net, therefore,
 the form of financing has become less favorable,
 even though there have been
 no serious problems so far

 The concern is that financing
 will become more difficult-with consequences
 to U.S. interest rates 
and the exchange rate-precisely
 when other factors make the U.S. slow 
and look an unattractive place to invest
 compounding the slowdown.

A final concern has to do with protectionism
 It is all too easy for politicians 
to blame other countries for imbalances 
- after all, foreigners do not vote

 The solution then appears easy
 Impose punitive tariffs! Yet as we have seen,
 the imbalances are a shared responsibility,
 and no one country will be able to solve 
it unilaterally,
 least of all by imposing tariffs.
 And a tariff here will bring forth a tariff there,
 potentially harming the entire world economy. 
We have seen the movie before 
in the depression of the 1930s 
and it is terrifying. 

It is to forestall such a descent 
into autarky that the Fund has been arguing 
that countries should avoid 
pointing fingers at each other. 

If instead countries 
see the imbalances 
as a shared responsibility,
 it will help guide the domestic debate
 in each country away from the protectionism 
that may otherwise come naturally.

What can be done? 
Consumption growth in the United States 
has to slow,
 and this will require a steady withdrawal
 of the massive amounts 
of fiscal and monetary stimulus 
infused in the post-bubble years.
 Exchange rate movements 
will also have an important role
 in facilitating the transition. 

This implies that a number of currencies,
 especially in Emerging Asia, 
will need to appreciate. 
And finally, in a large number of countries,
 including Japan, the Euro area,
 Emerging Asia, and oil exporters, 
further structural reforms 
are needed to increase domestic incentives 
to invest,
 and in some cases, consume.

Some people hanker after a grand accord 
along the lines of the Louvre or Plaza accords


 It is hard, however,
to think of what countries would, or could, commit
 to in such an accord, at least at this stage.
 Better to focus on building
 a common understanding of the problem
 and to convince each country 
of the importance 
of doing what is necessary. 
This is what the IMF has been doing 
for the last few years. 

There has been some progress, 
though less than we would like.
 For instance, 
the United States has agreed 
that reducing its fiscal deficit 
is part of the solution 
and is committed to reducing the deficit
 by half by 2009

 While the goal is welcome
 we believe the measures 
are not ambitious enough
 and some revenue raising measures 
will have to be contemplated
 especially in view of Hurricane Katrina's effect
 on broader U.S. government spending
 Similarly
 we welcome greater exchange rate flexibility 
in some countries in Asia
 especially the recent initial step 
in this direction by China-though further progress
 soon toward more flexible exchange rate
 management will be crucial.

Let me turn finally to an issue
 of some controversy
 Some have argued the Fund 
has been remiss in not pushing China
 to appreciate more
 with some economists
 asking for a huge step appreciation
 of the order of about 25 percent
 First, I reject the premise 
of the accusation
 The Fund has been discussing 
the need for greater exchange rate flexibility
 with China for some time 
- starting as early as 2000-
long before others woke up 
to the growing global imbalances

 Nevertheless, more action is needed.
 With the imbalances increasing,
 China's reserve build-up reaching enormous proportions,
 and China's current account surplus starting
 to grow significantly,
 it is in both the world and China's interest 
to allow the renminbi to appreciate more. 

However, a huge step appreciation
will probably do much more harm than good. 
For one, a number 
of the most efficient Chinese enterprises 
will be driven out of business 
and others forced into distress
 In a developed economy,
 the necessary restructuring 
could be speedily effected. 
In an economy like China's 
with an underdeveloped financial system,
 the restructuring would be long drawn-out,
 painful, and could even damage 
the banking system significantly. 
If there is one lesson we have learnt in recent years,
 it is that emerging markets 
do not handle large exchange rate
 movements well.
 Moreover, it is not even clear that
 such a large exchange rate appreciation
 would have much of an effect
 on the U.S. current account deficit 
- quite possibly other countries
 in Emerging Asia would simply take up 
China's export share. 

Instead, we would advocate 
a less interventionist approach
 where the authorities let the exchange rate
 react more flexibly to market forces
-the authorities already have a framework 
for this, and they should use it. 
A more flexible exchange rate, especially
 if accompanied by more flexibility
 in emerging Asia, 
will allow the underlying forces
 adjusting international demand 
more room to play. 
Equally important, however, for China, 
is the process of modernizing 
the financial system so that both banks 
and corporations face a realistic cost
 of capital, invest sensibly, 
and offer a realistic return to savers
 Not only can this reduce excessive
 investment in the Chinese economy
 it can also reduce excessive savings
 A growing China that consumes
 more will benefit not only itself 
but also the world.

Let me conclude.
 The world economy has been resilient 
in the face of shocks,
 in part due to improvements
 in the quality of policy. 
This has allowed a variety of imbalances to build up
 The IMF is concerned whether
 the needed transitions 
to reduce imbalances will take place smoothly
 which is why though the central scenario
 is one of robust growth
 we believe the risks are weighted
 to the downside
 Instead of pointing fingers
 at one another, or raising barriers against 
on another's goods,
 however, we should recognize 
that the need of the hour is sensible domestic policy reform
. In addition, of course,
 we should continue with the process 
of reducing trade barriers,
 which means working towards 
an ambitious Doha round.
 Let me end my remarks here. Thank you.