The Balance of Imbalances

There have been numerous Cassandra-like calls warning that global imbalances pose the largest risk to the world economy. Some observers will even place these imbalances at the heart of their explanation for the spasms in the market. There are only two problems with this view: the theory and the facts.

The conventional view embraces a 19th century mechanistic conception of economies. It was infatuated with balances. Modernity embraces imbalances. Chaos theory and work with large systems seem to emphasize the lack of balance in the classical understanding. A modern economy constantly is creating strains and stresses. Balances are the exception to the rule. Growth, which is the rule, means things are out of balance. Economic expansion requires supply and (effective) demand to be out of balance. The typography of capitalism is not a calm pond, but a tumultuous ocean.

The biggest risks to the world economy are not imbalances. On the contrary, the biggest risk to the world economy stems from efforts, such as protectionism, that seek to reduce imbalances quickly. Or remember last April’s G7 meeting, when the IMF took the unusual step of including an appendix to the G7 statement that sounded like they wanted the currency markets to bear a greater part of the adjustment of global imbalances. When the history is written, last year’s May-June swoon in emerging markets and slump in the dollar may, at least in part, be attributed to the G7/IMF signals.

The historian Niall Ferguson notes in his book The Cash Nexus: Money and Power in the Modern World, 1700-2000, that the average (current account) imbalance among the industrialized countries was larger 100 years ago then it is today. By most measures, given the greater mobility of capital now than then, the system is better able to cope with larger imbalances.

Leaving aside the issue whether imbalances are good or bad or too large, the actual imbalances have been reduced lately. The media and policy makers have done a poor job acknowledging and explaining this fact, which might help diffuse some of the budding protectionist sentiment.

Recall that prior to last April the G7 had identified a way to reduce global imbalances. The US would need to boost its savings. Europe and Japan needed to boost growth. Asia needed to adopt more flexible currencies. One of the best kept secrets is that this is exactly what has taken place. The US budget deficit—public dis-savings--has been reduced. European and Japanese growth have strengthened and Asian currencies are a bit more flexible.

The US external deficit, which three-years ago led the economics editor of the Financial Times Martin Wolf to pen an essay claiming that the US was “well on the road to ruin” has actually stabilized without the magnitude of dollar decline that many thought would be necessary. Indeed since the middle of last year, the 12-month moving average of the US trade imbalance has actually trended higher for the first time in nearly five years. The net export component of GDP is becoming a contributor to GDP not a weight.

The UK trade deficit is also stabilizing and, extrapolating from current trends, its external sector is likely to be a net positive contributor to GDP in Q3 or Q4 this year. It is true that Japan’s current account surplus, the biggest in the G7, might be rising again, but what is driving it has changed dramatically. Japan’s current account surplus on a month-to-month basis is not being driven by its trade surplus, which does appear to be growing, but by its investment income balance. Consider the most recent data. In January Japan reported a non-seasonally adjusted trade surplus of JPY114 billion. The investment income balance was JPY1.6 trillion. Of course, it is difficult to draw generalizations from a single snap shot, so look at a moving average. The 12-month moving average for the trade surplus stands near JPY816 billion. The 12-month moving average of the investment income balance is almost JPY1 trillion.

European and Japanese growth have improved over the past two years. Admittedly it is difficult to determine how much of the better growth performance is due to structural reforms as opposed to cyclical factors. It is though clear that Japanese banks are in a healthier condition than they were say at the start of the decade. And even the most cynical among us would recognize some structural improvements in at least parts of the euro-zone.

Asian currencies have become more flexible. The Chinese yuan and Malaysian ringgit are no longer pegged to the dollar. The pace of yuan appreciation has also increased, even if modestly so. It took ten months for the dollar to fall from CNY8.10 to CNY8.00. It took four months for the dollar to fall from CNY8.0 to CNY7.9. It took three months for the dollar to fall from CNY7.9 to CNY7.8. Yes it makes sense on a number of different levels for China to allow an even faster appreciation of its currency, but we (investors, policy makers and media) need to acknowledge that there has been movement and in the desired direction. Other Asian currencies have also appreciated against the US dollar and do not appear to be particularly limited, at least not obviously so, by the gradual appreciation of China’s yuan.

China’s trade surplus is still growing by leaps and bounds. The latest data, that covered the month of February, saw a 9-fold increase in China’s trade surplus from year ago levels. At $23.7 bln, its Feb surplus was the second largest on record. However there are two mitigating factors. The first is the distortion caused by the calendar effect of the Lunar New Year holiday. The second is that the affiliates of foreign firms account for roughly half of Chinese manufactured goods exports. China’s Commerce Minister recently noted that US companies accounted for more than $100 bln of China’s exports last year. Lastly, while much is made of China’s export prowess, it is also a large importer. Essentially China is an assembler for many products, with the actual value-added being accounted for by China estimated to be around 12%. It is this small slice that could be impacted by yuan appreciation.

Chinese officials are trying to promote stronger domestic growth. The government has boosted minimum wage (and there seems to be less talk there than here that a rise in the minimum wage will cause higher unemployment) and welfare spending. Retail sales in the Jan-Feb period rose 14.7% from year ago levels and 14.6% from Dec 06. The sales of appliances rose 22% and clothes sales rose 28%. General Motors, which might be experiencing a decline in fortunes in the United States, saw a 48% increase in auto sales in China from a year ago and is responsible for the second best selling auto model in the world’s fourth largest economy.

The point is that the fascination with balances in the modern economy is probably misplaced. To the extent that imbalances are important, the trajectory of many macro-economic developments is in the direction of smaller imbalances. The turmoil being experienced now in the capital markets may have numerous causes, but the macro-economic imbalances do not appear to be very high on the list.