Global Rebalancing: The Key Challenge in 2015

Andrew Hunt suggests that two things need to occur in the global economy before damage is done. China needs to be encouraged to export more capital via a liberalisation of its exchange controls and German households need urgently to be encouraged to become rather more risk-seeking.

Wednesday, December 3rd 2014, 6:00AM

by Andrew Hunt

By most of the available measures, the US current account balance is improving on the back of the country’s lower oil imports and some modest growth in exports, particularly within the aerospace sector. More significantly, we also find that the Eurozone’s aggregate current account balance has itself improved very significantly over the last few years, in part as a result of the widespread weakness in the economies of the periphery but also as a result of the change that occurred in the behaviour of German savers following the 2012 “rescue” of the Euro system.

It is now clear that German savers reacted to the European Central Bank’s attempted rescue of the Euro by significantly increasing their acquisitions of foreign financial assets, with the result that Germany began to run an overall balance of payments deficit, something that is not supposed to occur (for very long) when a country is operating within the awkward confines of a fixed exchange rate regime, such as the Euro. The German economy’s rather stereotypically efficient response to this deficit was to attempt to export more and even to limit its imports by suppressing domestic demand in Germany. While this was clearly not something that the ECB had wanted to occur (in fact, it wanted to see the reverse), it was something that has contributed significantly to the reported “improvement” in Europe’s aggregate current account balance.

Crucially, we find that this improvement within Europe’s current account position, when coupled with the more modest improvement within the US’s current account position, has implied that their combined annual current account balance (that is, that of the “West”) has improved by some USD800 billion since 2008 and USD300 billion since 2012 alone, to the point at which the West is now running its first “surpluses” for more than a generation.

For those of us that joined the economics profession/financial markets either during or soon after the mid-1980s, this change in what we might refer to as the West’s current account position is perhaps a seminal event. Ever since the early 1980s, we have grown used to Western consumers importing more than their countries were exporting, a situation that provided an explicit boost to the trading nations of the world and to the emerging markets.

Over the six years that have passed since the crisis phase of the GFC, though, the West has, to all intents and purposes, ceased to be a net importer and this amounts to a massive shift in the global status quo that we suspect is still under-appreciated by many.
If a country, or more particularly a group of countries, experiences an improvement in its current account balance, other countries somewhere else within the global trading system must experience the reverse, given that the world is a closed system. Consequently, we have seen a marked deterioration in Japan’s current account position since 2008 through both its continuing weak export performance and its now higher demand for imported resources. The deterioration within Japan’s current account balance has been of the order of USD$200 billion (in total) since 2008, with around half of this having occurred since early 2012.

We can therefore suggest that Japan has carried the burden of between a quarter and a third of the counterpart of the “West’s” improved current account position. Unfortunately for Japan, their part in this adjustment process has tended to occur via weak exports rather than notably stronger imports (export volumes are still down by roughly a quarter in comparison to their 2008 levels, while import volumes are essentially unchanged from 2008) and this type of adjustment has been highly deflationary for Japan’s domestic real economy. This is one of the reasons that Abenomics has failed to deliver the long-promised economic recovery.

Elsewhere in North Asia, we find that China’s official data suggests that the country’s annual current account balance has deteriorated by around USD250 billion in comparison to 2008, but it is also crucial to note that it has only deteriorated by around USD50 billion since 2012. Largely as a result of the massive domestic credit boom that occurred between 2009 and 2012, China’s very important share in the global adjustment process at that time occurred via a doubling in the value of the country’s imports. This was (highly) reflationary for the world at that time but, unfortunately, since 2012 we find that Chinese imports have tended to be relatively flat, while its exports have been a little stronger, at least “on paper”.

Consequently, we can suggest that between 2008 and 2012, China’s expansionary domestic policy settings (whatever their long term consequences for China may turn out to have been) were overtly supportive for global growth since they helped to facilitate the global trade adjustment process via an increase in imports/exports but, unfortunately, China has also proved that trade adjustments that are based primarily on “artificial” domestic credit booms rather than genuine reforms are rarely sustained over the longer term (as Japan also proved in the 1980s), with the result that China’s now-flat import trend and rising export trends have become deflationary for the world. Moreover, we would also note that China’s stronger exports despite its now-very-elevated real exchange rate have only been possible because China’s exporters have been prepared to accept lower than “normal” or efficient profits – a situation that makes China’s stance “doubly” worrying.

Staying within North Asia, we also find that Korea and Taiwan have seen their combined current account balance actually increase by USD100 billion since 2008, with half the improvement having occurred over the last two years. These countries, along with Singapore, have therefore not contributed to the global adjustment process despite their stronger exchange rates (particularly Singapore and Korea) and, in fact, they have tended to have the opposite and therefore unhelpful effect. It is time that the North Asian Development Model was evolved into something more flexible and less mercantilist.

Returning to the 2009-2011 “expansionary” period of the adjustment process, we find that the other notable “contributors” to the global trade adjustment process as the Western deficits reduced were Brazil, Indonesia and India, along with the many other countries within the EM and Frontier Market worlds that witnessed a marked deterioration in their current account balances during 2008.

Perhaps fortunately for world trade trends at that time, we find that the primary route by which these countries experienced the necessarily weaker current account balances between 2008 and 2013 was also via surging imports. Moreover, and as was the case in China, these surging imports can be viewed as having been the predictable byproducts of their own (albeit largely foreign-financed) domestic credit booms. As we have noted many times in these notes, the explosion of global capital flows that resulted from the West’s aggressive adoption of quantitative easing policies led to extraordinarily large flows into the banking systems of many of the emerging markets, with the result that severe domestic credit booms ensued in the recipient countries. These credit booms then exerted a predictable impact on the countries’ rates of domestic demand growth and hence on their demand for imports.

In effect, we would argue that the emerging markets became the world’s new credit-dependent marginal “consumers” of traded goods as their deteriorating current account balances and rising debt ratios showed all too clearly at the time.

To summarise, we would assert that of the USD$500 billion contraction in the West’s current account deficit that occurred between 2008 and 2011, China accounted for around 40% and Japan 20%, while India, Brazil and the various other “massively hyped” emerging and frontier markets accounted for the lion’s share of the remainder of the adjustment process via their own credit-induced surge in demand for imported consumer goods, aircraft and, in some cases, machinery. Unfortunately, while these EM credit booms appeared to make for what seemed to be an expansionary and “easy global trade adjustment process” at the time, we are all too aware that such artificial, rather than structural, trade adjustments are rarely long-lasting.

Since 2012, though, we find that the slowing in China’s domestic credit boom has implied that it has only been the counterpart of about 15% of the West’s improvement (this may also have been as a result of its non-profit-maximising export strategy as well), while Japan found itself unwittingly and certainly unintendedly accounting for around a third of the global adjustment burden despite its weaker currency policy. Even after Japan’s contribution, though, we find that the majority of the adjustment has had to be borne by others.

Within this catch-all category of “others”, we find that there are now essentially two types of economy. There are a dwindling number of economies, such as the UK, that still have rising import demand (normally as a result of their own continuing domestic credit booms) that is leading to deteriorating current account balances. While their situation is clearly reflationary for the global economy, there are now relatively few of these economies and their weak current account balances are having the effect of subduing income trends within their own economies, something that bodes ill for their ability to sustain their growth rates.

The second group within the adjusting economies are those countries that are simply experiencing very weak export trends and chief amongst these have been the commodity producers (although the UK is doing its part here as well). Countries such as Brazil and South Africa are finding that their part of the global adjustment process has in a sense been forced upon them by very weak export trends, something that is damaging for their current growth rates.

Unfortunately, what is also noticeable is that many of the countries that are currently suffering from the type of weak export trends that we describe above were already running significant current account deficits of their own. This situation implies that their need for foreign funding is increasing at a time in which their fundamental economic positions are deteriorating. Admittedly in the post-QE-world of surging capital flows, it is by no means impossible that this extra funding will be forthcoming ad infinitum (or even more), but even if these flows are forthcoming, this represents a potentially unstable situation – any number of economic or exogenous events could occur either globally or domestically that could lead foreign investors or lenders to suffer a change of heart.

At that point, the debtor/deficit countries would need either to raise interest rates (which would be deflationary for them) or they will be obliged to allow their currencies to decline, potentially quite precipitously to both make their economies notionally more competitive and make their assets more attractive to others. While this process might be beneficial for the individual country were it to happen in isolation (as it was for India and Chile last year), this type of adjustment would be deflationary for everyone else. Moreover, if too many countries were to attempt this simultaneously, it would be very deflationary for global growth and probably of little net benefit to the perpetrators.

In practice, we would argue the aggregate funding that the deficit countries need can only be obtained from either the US (by virtue of its reserve currency status, although this effect seems to be diminishing) or from the major surplus economies’ recycling of their current account/savings surpluses. Individual deficit countries can compete successfully with each other for a greater share of the existing available supply of funding via their interest rate, tax and currency policies (as again India has proved) but in aggregate, the required funding has to, in effect, come from either the reserve currency or from the surplus economies recycling their excess savings back into the borrowing countries. If the savings surpluses are not recycled, though (as they were not in 1929 and at times during the mid-1970s), then it seems probable that a significant number of the deficit countries will be obliged to devalue, raise their interest rates and subdue their economies. From this point it would be a relatively short step to the type of deflationary scare that financial markets might react to quite negatively.

To avoid this unwelcome global outcome, we would suggest that the US needs to continue exploiting its reserve currency status to the best of its abilities and that the surplus economies – principally China, the Middle East and Germany - need to be encouraged to export as much capital as possible.

Unfortunately, China’s savers remain constrained by their admittedly increasingly porous capital controls and the recent fall in the Chinese property prices may lead to some form of deleveraging cycle in China that encourages its savings to be “swallowed up” domestically in debt deflation. Meanwhile, German investors seem to have become notably more risk averse over recent months as they have begun to fear the threat of deflation rather than inflation. More positively, the FRB seems to understand that it cannot tighten aggressively given the impact that such a move might have on the economy’s ability to export capital.

In summary, the closure of the West’s current account deficit and its move into a surplus is forcing a rebalancing of global trade patterns – the process of rising trade imbalances between the West and the EM that began in the 1980s is finally going into reverse.

During the 2009-2012 period, this rebalancing was made notably less painful and at times even quite expansionary by the emergence of China and some of the other large EM countries as a, albeit temporary, source of demand for global imports. The ending of the credit booms in these countries, though, has – predictably – led to an end to this “positive” form of global adjustment. Moreover, Singapore, Taiwan and Korea are also failing to take part in the global adjustment process, presumably as a result of their own structural rigidities.

We can certainly argue that these countries’ continued adherence to the North Asian Development Model is beginning to have a very adverse impact on global trade and efficiency trends. In particular, North Asia’s intransigence with regard to its current account balances (and Japan is attempting the same approach, albeit much less successfully) has implied that the onus of the necessary trade adjustment has fallen on the commodity producers, other less aggressive EM and even on some of the frontier markets.

It does certainly seem that the commodity producers have been particularly vulnerable during this process and certainly we would regard the weakness in commodity prices at present as being an integral part of the adjustment process that we have described above; the need to reduce some of the world’s trade surpluses (Middle East) or widen some of the current account deficits (LATAM & Australasia) as part of the necessary adjustment process to the emergence of the West’s current account surplus is being manifested in weak commodity incomes.

These weaker income trends are impacting these countries’ domestic economic situations. Moreover, it is also true that many of the countries that are being required to suffer weaker trade accounts already possess relatively weak current account positions and hence they face a pressing need to attract yet more foreign financing from the surplus economies. Were this financing to dry up, though, then the economies concerned would be obliged to close their current account deficits as well via a further reduction in their own demand for imports. This situation would represent a mathematical impossibility on a global scale but at this point we suspect that world trade prices would likely collapse and a deflationary scare/cycle would grip financial markets.

For this almost-Armageddon type of outcome to be avoided, we would suggest that two things need to occur before too long: China needs to be encouraged to export more capital via a liberalisation of its exchange controls (something that is happening over time but perhaps not quickly enough) and German households need urgently to be encouraged to become rather more risk-seeking.

Unfortunately, the ECB’s delay in implementing a response to Europe’s latest slowdown is not only risking Eurozone growth and perhaps even the Euro’s own longevity, it is playing Russian roulette with the global economy. At the very least, we can suggest that there is now no margin for error at the ECB. For now, financial markets seem to have become enthralled by what Europe’s public sector may do next year and this should be enough to support risk markets over the very near term but, before too long, these entities are going to have to “deliver the goods” or the sea change that is occurring within global trade will have potentially severe deflationary consequences for the global economy.

Andrew Hunt
International Economist, London

Andrew Hunt International Economist London

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