Saturday, July 9, 2011

Current Account Imbalances

Now that's a title that may not excite the interests of many readers, but the current account and the wider balance of payments is a vital measure to interrogate a country's economic relationships with the rest of the  world. 

One factor used to explain the global financial crisis (at least as a partial explanation) are the substantial global imbalances between surplus and deficit countries. 

There were several major contentions about the global imbalances between deficit and surplus countries before the financial crisis hit. While the initial focus of most analyses of the global financial crisis was on the absence of suitable regulation, it is necessary to consider both micro (regulatory) and macro (global capital flows) factors behind the crisis. The absence of effective regulation was ultimately responsible, but the huge and unsustainable global imbalances between deficit and surplus countries, and particularly the imbalances between the United States and China played a fundamental role. China bought US dollars to maintain the low value of the renminbi against the US dollar to sustain the competitiveness of its export industries. 

The US CAD, which is predominantly a trade deficit rather than an income deficit – was five times the next largest CAD in 2007.  A common criticism was that US profligacy – high levels of spending and low levels of saving – led to a high current account deficit (CAD). But it is also possible to explain imbalances by looking at surplus countries and consider whether it is the capital account (financial flows) that explain imbalances rather than the current account (trade  and income flows). 

Many argue that what is required is a gradual rebalancing of global capital flows with the United States saving more and consuming less, and becoming less reliant on foreign investors to fund its CAD; and China and other surplus countries taking action to stimulate demand within their own economies. For the Chinese people to spend more requires them to save less. But this will not happen unless the Chinese government provides more certainty for the population through spending on public health and welfare. Both deficit and surplus countries will need to make adjustments and this will require deft negotiations.

It is possible that the global recession has forced some changes. The United States is attempting to reduce both consumption and debt, and China’s latest five-year plan advocates rebalancing the Chinese economy towards greater household consumption.

The danger is that a long-term unwinding of debt in the United States and other economies is likely to see a prolonged period of slow growth. Increased consumption in China is likely to be beneficial over the long term for the Chinese people but as the West buys fewer Chinese goods it should also mean (eventually) a period of adjustment for the Chinese economy.

A recent speech by Guy Debelle, "In Defence of Current Account Deficits" argues that imbalances should not necessarily be seen as bad. 
[T]he US current account deficit through the 2000s was the net balance of very large capital inflows and outflows. Much of the inflows were into either US treasuries or to US mortgage securities and related products, while a sizeable share of the outflow was foreign direct investment by US corporations. The US was able to earn relatively more on its stock of foreign assets than it paid on its foreign liabilities such that its net income position was often in surplus.Some of the flows were ‘bad’, at least ex post, such as those which found their way into poor-performing securities. However, very few were able to identify ex ante the distortion that was generating these ‘harmful’ flows. Other flows were clearly ‘good’. But the point to make is that focusing on the net balance of these flows, which is the current account position, is not particularly helpful relative to more scrutiny of the various components of the gross capital flows.
To justify his position he applies the logic of current account balances across generations and across the states in Australia. 
To mount a defence of current account deficits, I would like to provide a bit of context with which to think about this issue. One place to start is with an overlapping generations model of a closed economy, which we can think of as a country. Within this country there are households that are at various stages of their lifecycle. The younger working households save, the middle-aged households borrow, while the older households run down their stock of accumulated saving. So we have ‘imbalances’ across the household sector. The young households have current account surpluses, the middle-aged households like me are in current account deficit. But these ‘imbalances’ are not generally cause for concern. It would not be socially desirable if there were no cash flows between households.
Alternatively, we could consider the Australian states. At any point, there can be large current account positions between the Australian states. There are large financial flows across state borders too. Are we even aware that this is the case and should we be concerned? By and large, we should not. Again it is useful to think about why any such imbalances across the Australian states are not a cause for concern. Here we are straying into the optimal currency literature, most famously associated with Robert Mundell, which is currently getting a fair working over in the context of the problems of the European periphery.
Some of the reasons we are not concerned about the current account ‘imbalances’ of the Australian states is that the Australian states have a common currency, a federal fiscal system, sizeable interstate labour mobility (of which me and much of my Adelaide cohort are a good example of) and generally experience similar economic shocks.  These are the main prerequisites identified for an optimal currency area.
He argues that those who worry about a precipitous narrowing of the CAD imbalances. 
Such a scenario does not directly translate into a world of floating exchange rates. In that environment, the main mechanism of adjustment is the exchange rate. If global investors reduced their appetite for investment in a particular country, the exchange rate would depreciate until the point where investors would be happy once again with their allocation to the country in their overall portfolio. While the exchange rate might overshoot in this scenario, the depreciation is stimulatory to the economy, whereas in the fixed exchange rate world, the adjustment is contractionary.
In sum, Debelle's point is that the composition of the capital flows matters more than the imbalances themselves.
The conclusion I wish to draw then is that there can be perfectly good reasons why current account balances are not zero, and indeed can even be quite sizeable, without them constituting imbalances or being a cause for concern. The accompanying capital flows are often beneficial. This is not to say that they should not be scrutinised but rather that the scrutiny should really be on the nature of those capital flows to examine whether they are being driven by inappropriate policies or distortions.
The view that a CAD or imbalances are not a problem is particularly relevant for Australia, given that we have run deficits for long periods. Our deficits have been income driven, although trade factors have also been important. 
From the early 1990s until 2007, Australia recorded a current account deficit which averaged around 4¼ per cent of GDP. There were cycles around that level, with the current account narrowing to 2 per cent of GDP in 2001 in the aftermath of the Asian crisis and widening to around 6 per cent of GDP in 2007. 

At the same time, there was reasonable stability in the major components of the capital account. The inflow arising from the offshore funding of the banking sector was around 3½ per cent of GDP. This led to the common assessment that the Australian banking sector was ‘funding the current account’.
In my opinion, this analysis is incomplete. As mentioned earlier, a current account deficit and its equivalent capital account surplus is the net outcome of considerably larger gross flows. This is evident in Graph 1. Through this period there was substantial Australian investment abroad, particularly in the form of equity. Much of this was the result of the Australian superannuation sector investing a sizeable share of their funds in offshore equity markets. At times, there were also sizeable equity inflows to Australia.
Over the past few years, the composition of these capital flows has changed quite significantly, providing some contrary evidence to the hypothesis that the banks fund the current account. I don't think there was any particular problem with the structure of these capital flows previously, nor do I think there is one now.
In 2010, the net inflow to the Australian banking sector was close to zero (Graph 2). Indeed, over the last three quarters of 2010, the Australian banking sector was a net repayer of its offshore liabilities. That is, maturities exceeded issuance. This did not reflect a lack of appetite for Australian bank paper, as the cost of issuance was broadly flat or even slightly lower over the period. Instead, as I discussed in a recent speech, it reflected the fact that the banks had less need for wholesale borrowing given the conjuncture of fast deposit growth and subdued asset growth. The terming out of the banking sector's funding is also evident in the decline in the stock of short-term foreign liabilities but an increase in their longer-term liabilities.
This picture is reinforced if we include flows into Australian non-bank securitised assets (Graph 3). After net inflows amounting to around 1–2 per cent of GDP through the first half of the 2000s, there have been net outflows over the past three years. This change in net flows reflects the sharp drop-off in global appetite for securitised products as the problems in the US housing market came to the fore. The decline in demand for Australian securitised assets in part reflects the fact that a lot of the buyers of the paper pre-June 2007, structured investment vehicles, are no longer around.[12] Recent developments suggest appetite for these assets is growing again, both on- and offshore.

In 2010, while the banking sector's net offshore borrowing was zero, the current account deficit, while narrower than earlier years, was still 2½ per cent of GDP. An increase in foreign purchases of Australian government debt and decreased Australian investment abroad offset the decline in net capital inflow to the banking sector.
Turning to the current account side of the balance of payments, the notable development has been the shift in the trade balance from deficit to surplus as the much-commented-on rise in Australia's terms of trade has significantly boosted resource export earnings. In that respect, it is sometimes remarked that absent the terms of trade rise, Australia's current account would be markedly wider. But that ignores the fact that the exchange rate has also appreciated significantly alongside the rise in terms of trade, thereby reducing the boost to export earnings as well as causing changes in domestic absorption and production.
Another effect of the rise in the terms of trade has been on the net income deficit. Because a sizeable share of Australia's resource sector is foreign-owned, the increased income of that sector partly ‘leaks’ into a higher payment to the foreign owners, either in the form of dividend payments or retained earnings, thereby increasing the net income deficit. This also would not be occurring if the terms of trade were not at their current level.
A very interesting paper, indeed.

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