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Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied Economics V University of the Basque Country UPV/EHU Conference “International Economic Policies, Governance and the New Economics” The Cambridge Trust for New Thinking in Economics Cambridge, Thursday 12 April 2012

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Page 1: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Global imbalances as constraints to the economic recovery in developed

economies.

Jesus Ferreiro, Patricia Peinado and Felipe SerranoDepartment of Applied Economics V

University of the Basque Country UPV/EHU

Conference “International Economic Policies, Governance and the New Economics”

The Cambridge Trust for New Thinking in EconomicsCambridge, Thursday 12 April 2012

Page 2: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Do Current Account Imbalances (CAIs) matter?

• CAIs involve financial flows. High CAIs involve high net financial (in/out)flows, and the latter may be a source of problems (via interest rates, exchange rates…)

• CA deficits may be generated by fiscal deficits, leading to the possibility of twin crises (BoP and fiscal crisis)

• Permanent CA deficits lead to the accumulation of external debt. Problems in case of sudden stops

• CA imbalances involves:– a trade deficit that constrains the economic activity– a trade surplus that involves an export-led growth

strategy, whose long-term sustainability depends on the economic activity in foreign partners

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Page 3: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Can CA Imbalances be a problem for the World economy?

Current Account imbalances can be a source of systemic risks depending on the:

• Size of the imbalances• Trend (conjunctural or structural nature)• Concentration in a low/high number of countries• Extension of the phenomenon: number of countries with

high CA imbalances

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Page 4: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Size of Current Account Imbalances

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Current Account Balances (billions US dollars)

Deficit CAB Surplus CAB

Page 5: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The size of the CAI is measured as the average of the sums of the absolute values of the CA deficits and surpluses as percentage of the World GDP

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Current Account Imbalance as % World GDP

Page 6: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The evolution of the current account imbalances shows a clear rising trend:

• 1980-1999: 1.26 per cent World GDP• 2000-2011: 2.21 per cent World GDP

Is this evolution the result of a cyclical pattern, a long-term smooth trend, or the result of a structural break in the framework of foreign trade relations?

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Page 7: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Trend of Current Account Imbalances

To test this hypothesis we have applied a structural time series analysis to the behaviour of the size of current account imbalances in the world economy.

The model tested is:

where μ is the level, ψ is the cycle, and ω an intervention (dummy variable)

The stochastic trend (level+slope) component is specified as:

We include 3 interventions variables : years 2001 and 2009 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the level in year 2000 (taking the value 1 since 2000)

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Page 8: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Summary statistics Var1 T 32.000 p 5.0000 std.error 0.14639 Normality 4.9227 H(8) 0.51530 DW 2.2448 r(1) -0.23878 q 9.0000 r(q) -0.038520 Q(q,q-p) 12.007 Rd^2 0.69100

Variances of disturbances: Value (q-ratio)Level 0.000000 ( 0.0000)Slope 7.81691e-006 ( 0.007854)Cycle 0.00446176 ( 4.483)Irregular 0.000995301 ( 1.000)

Cycle other parameters:

Variance 0.04744Period 7.44442Frequency 0.84401Damping factor 0.95182Order 1.00000

State vector analysis at period 2011 Value ProbLevel 2.17949 [0.00000]Slope -0.21398 [0.02726]Cycle 1 amplitude 0.33856 [ .NaN]

Regression effects in final state at time 2011

Coeffi cient RMSE t-value ProbOutlier 2001(1) -0.22155 0.07511 -2.94954 [0.00681]Outlier 2009(1) -0.48065 0.07495 -6.41261 [0.00000]Level break 2000(1) 0.22388 0.11973 1.86994 [0.07325]

The model shows a significant structural break (equivalent to 0.22 p.p. world GDP) in the size of CA imbalances that took place in 2000

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Page 9: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Page 10: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The models shows that since 2000 the size of current account imbalances has a rising trend.

This involves that the problems (directly and/or indirectly) generated by these imbalances are more intense than in the past

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Page 11: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Concentration of world disequilibria in the current account balance

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Year Accumulated percentage of the disequilibria

Surplus countries Deficit countries

1980 25% Saudi Arabia Italy, Germany, Brazil 50% Saudi Arabia, Kuwait Italy, Germany, Brazil, Japan, Mexico, Poland, Canada,

Korea, Spain 75% Saudi Arabia, Kuwait, United Arab Emirates, Qatar, Libia,

Nigeria Italy, Germany, Brazil, Japan, Mexico, Poland, Canada, Korea, Spain, Belgium, Australia, Sweden, France, Austria, Iran, Turkey, Ivory Coast, Argentina, Philippines, Romania, Ireland

1990 25% Germany, Japan USA 50% Germany, Japan, China USA, United Kingdom, Italy, Canada 75% Germany, Japan, China, Taiwan, Switzerland, Venezuela,

Netherlands, United Arab Emirates USA, United Kingdom, Italy, Canada, Spain, Australia, France, India, Mexico, Thailand

1995 25% Japan USA 50% Japan, Netherlands, Italy USA, Germany, Australia, Brazil 75% Japan, Netherlands, Italy, Switzerland, Belgium, Singapur,

France USA, Germany, Australia, Brazil, United Kingdom, Thailand, Hong Kong, Korea, Malaysia, Austria, Indonesia, India, Turkey

2000 25% Japan, Russia USA 50% Japan, Russia, Switzerland, Norway, France, China USA 75% Japan, Russia, Switzerland, Norway, France, China,

Canada, Kuwait, Saudi Arabia, Iran, Korea, United Arab Emirates, Venezuela, Libia, Singapur

USA, United Kingdom, Germany, Brazil

2007 25% China, Germany USA 50% China, Germany, Japan, Saudi Arabia USA, Spain 75% China, Germany, Japan, Saudi Arabia, Norway,

Netherlands, Singapore, Sweden, Kuwait, Switzerland, Taiwan

USA, Spain, Australia, Italy

2011 25% China, Germany USA 50% China, Germany, Japan, Saudi Arabia, Russia USA, Turkey, Italy, France 75% China, Germany, Japan, Saudi Arabia, Russia,

Switzerland, Norway, Netherlands, Kuwait, Qatar, Taiwan, Singapore, Sweden

USA, Turkey, Italy, France, United Kingdom, Canada, Brazil, Spain, India

Page 12: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Current account imbalances (billions US dollars)

3 higher deficits 3 higher surpluses Cumulated deficits Cumulated surpluses

Page 13: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Three highest CA imbalances as a percentage of total imbalances

3 higher deficits 3 higher surpluses

Page 14: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Extension of CA imbalances: number of countries with high imbalances

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CA deficit ≥ 4% GDP CA surplus ≥ 4% GDP other countries

Page 15: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Page 16: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Reasons of Current Account Imbalances

1. Real versus financial causes:

• Based on current account (CA) balance: disequilibria in BC lead to disequilibria in BK– (S-I) (X-M)– (X-M) (S-I)

• Based on capital account balance (Bracke et al, 2008): disequilibria in BK lead to disequilibria in BC:– Asian crisis– Underdeveloped financial sectors in Emerging Market

Economies

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Page 17: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

2. U.S. versus rest of the world (EMEs) origins:

• USA:– Rise of US productivity growth (Hunt and Rebucci,

2005; Engel and Rogers, 2006; Bracke et al, 2008; Kroszner, 2008)

– Increases in private consumption and declines in saving rate (Bernanke, 2005; Kroszner, 2008)

– Attractiveness of US financial system (Bernanke, 2005)– Dollar liquidity and low US policy rates since

2001(Bibow, 2008-9)– Special international status of US dollar (Bernanke,

2005)– Rise of US household consumption not offset by

declines in the spending of other sectors (Gruber and Kamin, 2009)

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Page 18: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

• Rest of the world (EMEs, aged developed economies, oil exporters)

– Global savings glut - investment draught (Bernanke, 2005, 2007; Rajan, 2006)

– Rise in Chinese saving rate– Chinese public savings glut (Hermann and Winkler, 2009)– Weakness of financial systems in developing economies

(Bracke et al, 2008, Kroszner, 2008, Hermann and Winkler, 2009)

– Financial crises in EMEs lead to build up foreign exchange reserves as a buffer against capital outflows (Aizenmann and Lee, 2007; Aizenmann and Sun, 2009; Bernanke, 2005; Gruber and Kamin, 2009; Hermann and Winkler, 2009; Lee, 2009; Cova et al, 2009)

– Sharp in oil prices (Gruber and Kamin, 2009)– Domestic demand stagnation in some developed countries

(Bibow, 2008-9)– Ageing in developed economies

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Page 19: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

– China’s policies (Corden, 2009): exchange rate policy, build-up of foreign exchange reserves as a form of self-protection (parking theory), high household and corporations savings

– Massive excess supply of labor in Asia (Dooley et al, 2009)

– Financial liberalization in Emerging Asian Countries (Dooley et al, 2004; Chadha, 2006; Caballero et al, 2006)

– Financial liberalization plus higher productivity growth in the rest of the world (Chakraborty and Dekle, 2009)

– Productivity slowdown in the nontradeable sector of emerging Asia (Cova et al, 2009)

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Page 20: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

3. Mixed Origin:

• Bretton Woods II (Dooley et al, 2003): symbiosis of interest among US and surplus developing countries: Developing countries base their development in exporting to US; the US finance its CA deficit by selling safe financial assets, which provide the collateral for inward FDI in developing countries

• Differences in financial development: spending in the US is more responsive to lower costs and higher availability of credit stemming from the global saving glut than other advanced economies (“spending response” hypothesis: Gruber and Kamin, 2009)

• Differences in the productivity growth: higher TFP growth in the US nontradable sector and higher TFP growth in the tradable sector of the rest of the world (Obstfeld and Rogoff, 2007; Cova et al 2008)

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Page 21: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

All these hypothesis have problems:

• The assumption of a direct relationship between financial and current account flows

• They can not explain why the desire/objective of some countries to generate a surplus in their current accounts (accumulation of foreign reserves) can effectively be materialized

• They can not explain why during the last decade, the generation and the rising size of current account imbalance is a generalized (and long-lasting) phenomenon, and why the increase in the number of deficit countries is higher than that of surplus economies

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Page 22: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The size and the evolution of these imbalances (and that of EU with China) is explained by a process of worldwide relocation of production of tradeable goods: a change in the global value added chain.

This process has been fuelled by FDI inflows from developed economies to emerging economies

Consequently, it is a structural-nature process that cannot be solved with short-term measures like exchange rate adjustments or macroeconomic (fiscal-monetary) policies

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Page 23: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Current Account Imbalances and FDI (% World GDP)

FDI flows CAI FDI stock

Page 24: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Structural break in the series of FDI flows

We have applied a structural time series analysis to the behaviour of the FDI flows in the world economy.

The model tested is:

We include 3 interventions variables : years 1999 and 2000 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the level in year 1998 (taking the value 1 since then)

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Page 25: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The results show a rising trend in the FDI flows and a structural break in 1998, equivalent to a permanent increase of 0.6 per cent of the world GDP

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Log-Likelihood is 29.3507 (-2 LogL = -58.7014).Prediction error variance is 0.051874

Summary statistics FDI flows T 31.000 p 5.0000 std.error 0.22776 Normality 2.3426 H(8) 19.134 DW 2.1309 r(1) -0.089814 q 9.0000 r(q) 0.10100 Q(q,q-p) 13.531 Rd^2 0.84615

Variances of disturbances: Value (q-ratio)Level 0.000000 ( 0.0000)Slope 0.000000 ( 0.0000)Cycle 0.0397524 ( 1.000)Irregular 0.000000 ( 0.0000)

Cycle other parameters:

Variance 0.15859Period 7.12684Frequency 0.88162Damping factor 0.86564Order 1.00000

State vector analysis at period 2010 Value ProbLevel 2.14618 [0.00000]Slope 0.06201 [0.00001]Cycle 1 amplitude 0.60289 [ .NaN]

Regression effects in final state at time 2010

Coeffi cient RMSE t-value ProbOutlier 1999(1) 1.03042 0.23280 4.42611 [0.00015]Outlier 2000(1) 1.50617 0.23185 6.49630 [0.00000]Level break 1998(1) 0.58385 0.20102 2.90439 [0.00741]

Page 26: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Page 27: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Structural break in the series of FDI flowsWe have applied a structural time series analysis to the behaviour of

the FDI flows in the world economy.

The model tested is:

We include 4 interventions variables : years 2002, 2005 and 2008 (outliers taking the value 1 for that years , and 0 for the others) and an intervention adopting the form of a break in the slope in year 1997 (taking the value 1 since then)

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Page 28: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

The results show a rising trend in the FDI stock and a structural break in 1997, equivalent to a permanent increase of 0.9 per cent of the world GDP

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Log-Likelihood is -5.86179 (-2 LogL = 11.7236).Prediction error variance is 0.955449

Summary statistics Stock FDI T 31.000 p 2.0000 std.error 0.97747 Normality 5.9052 H(8) 19.651 DW 1.4250 r(1) 0.18574 q 6.0000 r(q) -0.077398 Q(q,q-p) 2.0861 Rd^2 0.83958

Variances of disturbances: Value (q-ratio)Level 1.18448 ( 1.000)Slope 0.000000 ( 0.0000)Irregular 0.000000 ( 0.0000)

State vector analysis at period 2010 Value ProbLevel 19.80295 [0.00155]Slope 0.48508 [0.08676]

Regression effects in final state at time 2010

Coeffi cient RMSE t-value ProbOutlier 2008(1) -6.99891 0.76957 -9.09458 [0.00000]Slope break 1997(1) 0.82523 0.39829 2.07193 [0.04874]Outlier 2002(1) -1.79850 0.76957 -2.33702 [0.02775]Outlier 2005(1) -2.12150 0.76957 -2.75674 [0.01074]

Page 29: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

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Page 30: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

How to solve current account imbalances

Traditional solutions to solve a current account imbalance are:

• Demand-side policies: (T+G) + (S-I)=(X-M)– Current account deficits: restrictive fiscal-monetary policies– Current account surpluses: expansionary fiscal-monetary

policies

• Exchange rate policy:– Current account deficits: depreciation– Current account surpluses: appreciation

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Page 31: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

In the case of demand-side policies: • the reduction of CA deficits involves a negative impact on economic

activity• the reduction of CA surpluses assumes:

– that surplus country will increase the demand of goods-services produced abroad,

– that domestic agents absorb some of the production formerly exported

– that foreign partners will be able to generate the (higher) supply of these goods

– that there is a foreign supply of these goods

Option b may lead to higher prices of goods exported by the surplus country. If foreign partners do not increase the production of these goods (substituting imports by domestic production) and the demand of imports is highly inelastic, import prices in these deficit countries will rise, increasing the CA deficit

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Page 32: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

In the case of exchange rate policy:• The impact of changes in the exchange rate depends on the

elasticity of the demands of imports and exports• Highly inelastic demand of imported goods lead to a deterioration of

CA balances if the currency depreciates• A low sustituibility between domestic goods and imported goods

involves very high depreciation of the domestic currency• The impact on trade balances of changes in the real exchange rate

depends on the level of intra-industrial trade: in countries with low intra-industrial trade, the depreciation of the RER can deteriorate the trade balance (Kharroubi, 2011)

• A change in the exchange rate of a single currency might not affect the CA balance of a thirs partner, if the exports of the first country compete with other countries whose currencies do not change

• Empirical analyses (Altuzarra, Ferreiro and Serrano, 2010), using cointegration and VCM, show that a depreciation of the euro improves the trade balance with China, but a depreciation of the dollar deteriorates the USA trade balance with China

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Page 33: Global imbalances as constraints to the economic recovery in developed economies. Jesus Ferreiro, Patricia Peinado and Felipe Serrano Department of Applied

Conclusions• Current Account Imbalances are a source of potential (systemic) risks:

– Problems coming from the related financial flows– Constraints to the economic activity in deficit countries

• Current account imbalances have a structural nature:– The size of CAI has increased in the last decade– The number of countries with high CAI has increased– CAI is concentrated in a low number of economies

• Current Account Imbalances are explained by a process of worldwide relocation of production of tradeable goods (fuelled by FDI flows from developed economies): is a structural-nature process that cannot be solved with short-term measures like exchange rate adjustments or macroeconomic (fiscal-monetary) policies

• Adjustment of CA deficit involves a change in the productive structure (size and composition of aggregate supply) of the deficit country: need of supply-side policies (e.g., industrial policies, policies fostering FDI inflows...)

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