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*** Stephen Roach 9-21-03 ***


Global: Rebalancing Delayed

Stephen Roach (New York)
July 21, 2003

Global rebalancing is all about the restoration of a more sustainable equilibrium for a lopsided US-centric world economy. As I see it, only by shifting the mix of consumption from America to the rest of the world can the global economy avoid the painful endgame of a serious balance-of-payments crisis. For a while I was becoming encouraged that this scenario was playing out according to script. Now I am beginning to fear that the world is digging in its heels and resisting global rebalancing.

My concerns hinge mainly on recent developments in foreign exchange markets and on the response of politicians and policy makers to those developments. From the start, I felt that a significant shift in the world’s most important relative price -- the US dollar -- would be the central lever of global rebalancing. A weaker dollar puts pressure on a saving-short US economy to restrain domestic consumption and rebuild national saving. The related outcomes of a stronger euro and a stronger yen put comparable pressures on Japan and Europe to do the opposite -- to transform externally driven growth into support from domestic demand. As is often the case, what seems so logical in theory turns out to be much tougher in practice. For years, the Japans and Europes of the world have been either unwilling or unable to accept the heavy lifting of structural reforms that is so essential to unshackle domestic demand. My biggest fear has been that such politically and socially induced resistance could derail global rebalancing (see my May 27, 2003 Forum dispatch, “The Heavy Lifting of Global Rebalancing”). Those counter-forces now seem to be coming into play.

At least, that’s certainly the verdict that can be taken from recent public statements of the authorities in the United States, Europe, and Japan. US Treasury Secretary John Snow has been especially prominent in taking the initiative in “jawboning” currency markets in the past few months. First, he altered the rhetorical underpinnings of America’s so-called “strong dollar” policy. Then he expressed concern over China’s RMB peg, concerns that have since been echoed by Fed Chairman Alan Greenspan. And now Snow has apparently given the green light to further yen depreciation as a means to support the reform efforts of an ever-fragile Japanese economy. At the same time, Germany’s chancellor, Gerhard Schroeder, recently urged the European Central Bank to give due consideration to the foreign exchange value of the euro in promoting the competitiveness of European exports. But Japanese officials have been the most aggressive in attempting to manage currency markets. They have led the way in China bashing for over a year -- insisting that the renminbi needs to be revalued in order to neutralize the Chinese deflation threat and to stop the “hollowing out” of Corporate Japan. And they have engineered a massive campaign of direct intervention in foreign exchange markets in the first half of 2003 aimed at arresting the appreciation of the yen.

These reactions to a weaker dollar and the global rebalancing such an outcome would entail do not come as a surprise. There is enormous resistance to the structural reforms that would be required by a strengthening of currencies in Japan and Europe. Central to such reforms would likely be headcount reductions associated with a wrenching wave of corporate restructurings. With unemployment already high and rising in structurally impaired European and Japanese economies, a new outbreak of currency-induced layoffs could well trigger a backlash that threatens established political leaderships. The survival instincts of ruling power bases are understandably biased against such unsettling reforms -- they are more inclined to resist currency-induced adjustments that may upset the status quo.

There are times when the political solution may be at odds with the economic solution. That was certainly the case in the spring of 1995, when circumstances were not at all unlike those of today. At that time the yen had soared to a record high of ¥80 versus the dollar and there was sheer panic in Japan. The Japanese system itself was thought to be at risk, and draconian reforms were being contemplated by Japan Inc. In response, the world flinched, agreeing that a weakened Japanese economy could not withstand the pressures of a super-strong currency. The yen was then “allowed” to depreciate versus the dollar by about 45% over the next three and a half years. In response, the Japanese were let off the hook and never lifted a finger on macro reforms. The lesson of eight years ago has been all but forgotten by those such as US Treasury Secretary Snow who seems to harbor the mistaken impression that a weaker currency will give Japan the flexibility it needs to implement reforms. Experience tells us that the “stick” is far more effective than the “carrot” in creating a constituency for reform. Incumbent politicians will typically opt for the painless way out. And that’s exactly what they are doing right now.

But there are important economic implications of this politically inspired desire to perpetuate the status quo. By neutralizing the pressure for reforms, the world economy will remain on a US-centric growth path. And the world’s external imbalances will only get worse as a result. America’s current-account deficit, which hit a record $544 billion (annualized) or 5.1% of GDP in 1Q03, is already on a course to widen significantly further over the next 12-18 months. In large part, that’s a reflection of further declines in national saving brought about by outsize federal government budget deficits. For that reason alone, America’s external imbalance could well rise to 6.5% to 7.0% of GDP by the end of 2004 -- a shortfall that will have to be financed by capital inflows of approximately $3 billion per business day. But this forecast presumes some progress on global rebalancing will occur -- that the US economy will start to draw incremental support from export demand by a recovering global economy. To the extent that the rest of the world fails to deliver on the domestic demand front, that assumption can be drawn into serious question -- and America’s current account outlook will be even bleaker.

In the end, I worry that a dysfunctional world has opted for a strategy aimed mainly at buying time -- hoping that the longer-term perils of current-account adjustments will be ameliorated by the short-term benefits of the reflationary policy fix. The risk is that such a short-term fix may backfire. I continue to believe that policy traction will remain surprisingly elusive in a post-bubble US economy. To the extent I’m right, the external imbalances of a US-centric world can only intensify. But if I’m wrong and such policies now get traction in the US and elsewhere around the world, then suddenly there will be competing claims on global capital flows. Under such circumstances, it will be much tougher to finance America’s gaping current-account deficit without offering concessions to foreign investors -- concessions that could well entail higher bond yields and/or lower share prices. Either way, I see no easy escape from the imperatives of global rebalancing. It happens either though a fundamental realignment of currencies or by a full-blown international funding crisis.

At this point, the handwriting is on the wall: Politicians and policy makers around the world have played their cards. They are leaning forcefully against the fundamentals of currency adjustments that might otherwise be expected from the fundamentals of global rebalancing. In effect, the authorities are drawing a line in the sand against a further decline in the US dollar and a related appreciation of the yen and the euro. While that may delay rebalancing, it only heightens the possibility of a far more treacherous endgame for an unbalanced, US-centric global economy. As I see it, the longer the world avoids the imperatives of a US current-account adjustment, the greater the possibility of a wholesale flight out of dollar-denominated assets.

http://www.morganstanley.com/GEFdata/digests/20030721-mon.html