Global Imbalances are Growing and Increasing the Risk of a Disorderly Adjustment and Hard LandingBy Nouriel Roubini
Created: Aug 24 2005
SourceLast February Brad Setser and I wrote a paper on the risks of an unraveling of the Bretton Woods II regime and of a disorderly adjustment of the global current account imbalances. Since then the US dollar has sharply rallied and US long term interest rates have remained relatively flat and low. To those with panglossian or benign views of the global imbalances and to supporters of view of the long term stability of the BW2 regime, the financial developments of the last few months appear as a proof that global imbalances are not something we need to worry about. I will instead make the case here that we need to seriously worry - even more than before - about such imbalances and the risks of their disorderly unraveling.
First, I am worried that the recent rally of the US dollar and the fact that long rates have remained low (the infamous "bond conundrum") has led to dangerous complacency about these imbalances. I.e., there is a common and mistaken view that, since the dollar is strong and long rates are low in spite of these growing current account deficits, this is a proof that such deficits are not a problem and can be easily financed for a long time. I worry as, in my view, these two financial developments are leading to an exacerbation of the already large U.S. external imbalance: if the dollar had not rallied in the last six months, its earlier depreciation between 2002 and the end of 2004 could have started to impact the US trade balance (at least relative to the countries against which it had depreciated). Instead, the recent dollar rally ensures that any potential improvement in the trade balance from the previous depreciation will be aborted and that such balance will worsen over time. Similarly, the fact that long rates have remained low in the US also contributes to exacerbate the external deficit: with low long term interest rates, the housing boom continues unabated and leads to higher consumption and lower savings. And since the current account is the difference between national savings and national investment, low long rates are leading to a larger current account deficit. Indeed, as forecast by my co-author Brad Setser, this year the U.S current account deficit could be as high as $800-850 billion, a sharp increase relative to the already large $665 deficit of 2005.
Second, there is a similar complacency regarding the U.S. fiscal deficit. While the improvement in the US fiscal balance in 2005 is mostly due to temporary factors, the mood in Washington is one of supply-side giddiness that has no basis in reality. If one takes the official CBO forecasts and assumes that all the Bush administration tax cuts are made permanent (income tax, dividend tax, capital gains tax, estate tax, and fixing of the AMT) while government spending keeps on growing at a moderate pace close to nominal GDP (as it has even most recently), then by 2009 budget deficits could surge above $450 billion and become much larger in 2010-2015. So, our fiscal mess is here to stay and become worse putting further downward pressure on national savings and contributing to further worsening of the current account deficit. And the recent budget optimism in Washington ensures that this administration and Congress will take no action to address the dangerous and growing medium-term fiscal gap.
Third, US short rates are rising and the US net foreign liabilities are growing at the rate of the $800 billion current account deficit (before any valuation effects) and will be growing this year at the rate of $1,100 billion (after valuation effects as the strengthening of the US $ this year - if maintained- will imply massive capital losses on US holding of foreign assets denominate in foreign currency). This increase in short rates and increase in our net foreign debt implies that the U.S. net factor income payments will become negative for the first time in the third quarter of this year. So, net factor income will start to add to the current account deficit and this component of the deficit will rise to over 1% of GDP in the next couple of years.
Fourth, oil prices keep on going higher and their effects will soon start affecting consumption and the real economy. Note also that high oil prices directly contribute to a further worsening of the US current account. While the recycling of such petrodollars is for now going into OPEC savings that are parked in large part in US dollar assets, the prospect - as in past oil shock episodes - that oil exporters will soon start consuming such savings mostly on goods from Europe and Asia will create growing challenges for the financing of the US external deficit.
Fifth, the housing bubble is continuing but it may soon clash - and possibly crash - with the real income hit that high oil prices will impose on consumption. U.S. consumers now look quite overstretched in many dimensions: incomes and wages are not growing fast in real terms; the Fed tightening is increasing short rates, thus increasing interest rates on a wide range of consumer debt/loans and increasing debt servicing costs; the oil shock is reducing real incomes; thus, the housing market bubble may flatten if not burst. Therefore, this last installment of the oil shock may be the tipping factor that could trigger a consumption retrenchment, a bursting of the housing bubble and a significant economic slowdown.
Sixth, some have taken the tiny 2.1% Chinese currency move as sign that China will not move its currency much more than that and that the the BW2 regime of financing of the US deficit by China and Asia will continue for much longer. Instead, there are good reasons to believe that China will be forced - both by US protectionist pressures and by its own internal needs to control its financial bubbles and vulnerabilities- to move its currency much further, at least by 10% in the next year. And if China moves by 10% the rest of Asia will also move by 10%.
Seventh, this further currency movement by China and Asia will reduce the rate of reserve accumulation by these countries and significantly affect US long rates. A recent study by the Banque of France estimates that the effects of foreign forex intervention on US long rates could have been as high as 125bps in 2004. Now, consider the role of forex intervention in financing the US deficits. In 2004, the US current account deficit was $665 billion and about three quarters of it - or $500 billion - was financed by foreign central banks. This year the US current account deficit will be at least $800 billion and even larger next year. Now suppose that China and the other members of BW2 decide to allow some appreciation (say 10%) of their currencies and thus reduce - not stop altogether - the rate at which they accumulate dollar reserves. Say, reserve accumulation falls from $500 billion a year to only $300 billion. Then, there is a gap of $500 billion (or even higher at $700b if net FDI remains $200 b negative as in 2003-2004) in the US current account deficit that needs to be financed by private sources. Now, until recently such private financing of the US deficits has been quite sustained because of various factors including the fact that currencies in BW2 countries were stable relative to the US $ and thus private acquisition of US dollar assets via carry trades was profitable. But once China and the rest of BW2 allow their currencies to move more than 2% the expected capital losses on holdings of US dollar assets will imply that private investors will be much more cautious in accumulating further dollar assets. So, a China/Asia move of 10% in currency values will sharply reduce - on top of the reduced official financing - the private financing of the U.S. external deficit.
Eighth, during the coming fall the cyclical factors that were bullish for the dollar in the first half of 2005 will be dominated by the structural factors that lead to medium term dollar weakness. The cyclical reasons for the strong dollar in the first part of 2005 (US short rates going up, US growth outperforming that of Europe and Japan) will weaken as the Fed tightening brings the Fed Funds to neutrality by year end and as the US growth may slow down because of oil while there are signs of cyclical pick up in Japan and even in some parts of Europe. At the same time, the structural factors that tend to imply a weakening of the dollar will become stronger: as the US current account deficit will worsen and as the foreign willingness to finance it will shrink, the dollar will start falling again. A similar dynamics occurred in 2004: until the summer the dollar was strong or stable but once the fall of 2004 brought a string of bad news on the US trade balance, the dollar started to fall sharply. A similar pattern is likely to develop this fall and winter when bad structural news on the trade balance will be accompanied by a weakening of the cyclical factors that were supporting the dollar in the first half of 2005.
So, were we wrong on our prediction of an unraveling of BW2? Our prediction was always that the unraveling would occur in 2005 or 2006 and we listed in a long section of the paper a number of factors that would delay such unraveling in 2005. And indeed such delaying factors have been at play in the first half of this year. But you cannot fight forever the force of gravity: the structural factors that imply dollar weakness will re-emerge in the next few months in a situation where the US external deficit will be even larger than in 2004 and where the foreign willingness to finance it - as first signaled by a Chinese and Asian currency move that will accelerate over the next year - will increasingly shrink. Thus, large global imbalances that are currently growing rather than shrinking increase the risk of a disorderly adjustment of such imbalances and of a hard landing of the U.S. and global economy. So, fasten your seat belts in the fall as it's gonna be a bumpy ride!