Monday, March 9, 2009

Global Imbalances

In looking at the causes of the financial crisis, we have often focused on regulatory failure in the mortgage and finance industry. However, as well as regulatory failure there was a large global imbalance between East (mainly China and rest of Asia) and West (mainly US and UK). Many have felt this global imbalance caused, or at least exacerbated the current financial crisis.

What are the Global Imbalances?

  1. US ran a large and persistent current account deficit (imports higher than exports) of upto 6.5% of GDP in 2006
Diagram of Current Account Surplus / Deficit in US and rest of world
source: (1)
2. China ran a large current account surplus, accumulated foreign reserves, kept Yuan undervalued and relied on export growth.

3. Savings Glut in Asia. Low savings and high borrowing in US

The high level of savings in Asia was one factor behind the very low savings rate in the US.


Why Global Imbalances?

1. US Dollar world's Reserve currency. Because the US dollar is the world's reserve currency. There has been a large demand for US securities like Treasury bills. These capital flows have effectively financed the US current account and explains why the US has been able to run a larger current account deficit than most other countries.

2. Low Long Term Interest Rates. The high demand for US securities such as US Treasuries and mortgage backed securities helped keep US interest rates low.

For example, the real yield on ten-year inflation-indexed U.S. Treasury securities averaged about 4 percent in 1999 but less than 2 percent in 2004. The real U.S. interest rate (interest rate - inflation), showed a similar pattern, falling from about 3.5 percent in 1996 to about 1.5 percent in 2004 (source: Fed Reserve)

It made borrowing for the US cheaper. There was great demand for savings in the US. This encouraged a US banks to offer increasingly sophisticated forms of investment. It explains why there was so much high demand for US mortgage securities even though the risk was very high.

3. Undervalued Yuan. China has tried to keep the Yuan undervalued to boost its exports. This undervaluation of the Yuan has made Chinese exports cheaper and boosted the Chinese Trade surplus.
  • The US have blamed China for the imbalances pointing to the undervaluation of the Yuan. This has been at times a political football, with US politicians deriding the 'protectionist' exchange rate policies of China.
  • China have defended themselves saying the global imbalances were caused by the US decision to pursue low interest rates and lax standards in lending criteria. They argue it is their right to pursue their own exchange rate policy. Before, China, the US used to blame Germany and Japan.
4. Emerging market economies experienced sharp rise in current account surplus.
  • e.g. Oil producing countries benefitted from rising oil revenues due to higher oil prices.
  • Asian countries reduced investment and increased savings after South East Asian crisis of 1997
The aggregate current account position of developing countries swung from a deficit of about $80 billion in 1996 to a surplus of roughly $300 billion in 2004, a net move toward surplus of $380 billion.

Problems of Global Imbalances.

Basically, the problem is that the global saving glut made it easier for Americans to borrow and this encouraged an asset bubble (the current bubble could be in US Treasuries). I will look in more detail at this tomorrow.

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