Significant correction in external imbalances may eventually happen. Adjustment through the internal cost and price structure might involve less risk to monetary and financial stability than adjustment through exchange rate movements.
Those with an interest in macroeconomics will have come across the fundamental concept that, for an economy with trading and economic relationships with the rest of the world (an "open" economy), the difference between domestic savings and domestic investment (or gross domestic fixed capital formation) is the equivalent of the current account balance. This is an algebraic relationship that can easily be demonstrated by re-arranging the familiar equation, which expresses GDP (or Y) using the expenditure approach: Y = C + I + G + X - M. Here, C, I and G represent private consumption, investment and government spending, while (X - M) is the trade balance in goods and services. One can also interpret Y in broader terms as income available for consumption and investment (that is, adding net factor income and current transfer to GDP) and (X - M) as the current balance (trade balance plus net factor income and current transfer). Then, defining domestic savings (S) as the difference between income and private and government consumption (S = Y - C - G), and rearranging the equation will give the relationship (S - I) = (X - M). The new equation essentially says a current account deficit represents a shortfall of domestic savings to finance investment. Although this algebraic relationship is simple, understanding the causal relationship between the two sides is a lot more complicated, particularly when the size of the various components, for example the current account balance, is often politicised at an international level.
The external imbalance of the United States ─ or the global imbalance, since the external imbalance of the largest economy in the world is as much a problem for the rest of the world as it is for the US itself ─ has been the focus of international attention for some time, in both the academic and policy spheres. It is doubtful whether the imbalance can be sustained, but the fact is that it has been there for longer than anyone expected and it keeps expanding. The US current account balance continues to be financed quite easily through borrowing from overseas because of the willingness of those with domestic savings exceeding domestic investments to hold claims against US residents.
The rational explanation for this phenomenon is that the risk-adjusted expected rate of return of holding US assets is higher than that of domestic investments and that of investments in other parts of the world. Indeed, there are few alternative explanations. An interesting one is the decline in "home bias" very well articulated by Alan Greenspan, the former Chairman of US Federal Reserve. He said that "home bias is the parochial tendency of persons, though faced with comparable or superior foreign opportunities, to invest domestic savings in the home country" He pointed out that, starting in the 1990s, home bias began to decline discernibly, as a "consequence of a dismantling of restrictions on capital flows and the advance of information and communication technologies that has effectively shrunk the time and distance that separate markets around the world" Investors - vision has been broadened by information technology to a point where foreign investment appears less risky than it did in the past. This decline in home bias has been, he pointed out, manifested empirically by a fall in the correlation coefficient between national savings rates and domestic investment rates from 0.97 in 1992 to 0.68 in 2004.
Interestingly, perhaps as a result of having been brought up in a colonial environment, I have observed, admittedly from a narrower perspective, an opposite phenomenon: a "xenophilia" (opposite of xenophobia) mentality in our part of the (developing) world that manifests itself in a "developed economy bias" in the assets that we hold. This is understandable considering the large gap between the developed and the developing economies in many respects, at the social, political, economic and technological levels. Indeed, the international investment position, measured against GDP, of Asian economies is fairly high (Hong Kong being the highest in the world in 2004), and much of those international investments is in the developed markets. As the developing economies progress and the risk-adjusted expected rate of return in domestic investments (or investments within the region) rises relative to those of the developed economies, and as the growing concentration of claims against US residents leads logically to diversification, a significant correction in the external imbalance may eventually occur. This phenomenon could be described as a reversal of the decline of the home bias.
Meanwhile, debate on the external imbalance suggests that there is inadequate domestic consumption (excessive saving) or investment, or more conventionally the exchange value of the currency of the surplus economy is too low. There is consequently a tendency to prescribe more flexible exchange rates as the panacea for correcting external imbalances. While this might be the right policy response in many cases, it is of course not the only alternative to adjustment, if adjustment is needed. One should not assume that price elasticity of imports and exports is such that an exchange rate appreciation would necessarily reduce the current account surplus, or conversely an exchange rate depreciation would necessarily reduce the current account deficit. In addition, in view of the tendency of exchange rates to overshoot their equilibrium values, the adjustment process may create unnecessary volatility. An alternative adjustment process, which may involve less risk to monetary and financial stability than exchange rate adjustments, may be to allow market forces to work through the internal cost and price structure. This alternative process may take a little more time, but as long as the economy is adequately flexible, it may be the safer alternative.
Joseph Yam
2 March 2006
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