The global external imbalance is unlikely to be resolved by exchange rate adjustments.
A popular subject discussed in many international forums is the so-called global external imbalance. Specifically, this refers to the large current account balance of payments deficit that the United States has been running. This is currently equivalent to about 5% of US GDP or US$550 billion. With net foreign debt approaching US$3 trillion, the situation is considered by many to be unsustainable. Since the US is the largest economy in the world, and there seems to be a lack of politically acceptable policy responses domestically to tackle the problem, it is considered everybody else's problem as well. And so, rather than a problem of "the US current account deficit" it is called a problem of "global external imbalance". Rather than the traditional policy prescription that aims at increasing domestic savings to finance domestic investments in the US, including curbing the large budget deficit, there is much greater focus on what everybody else should be doing to correct the imbalance.
To be sure, globalisation has meant greater interconnection and interdependence between economies trading with each other. And when you are as big and as open as the US, a US problem understandably becomes a global problem. But it is interesting to look at this US problem from the point of view of the rest of the world, as indeed the rest of the world is collectively running a current account surplus equivalent to the size of the US current account deficit. The Mainland of China, which has been portrayed as an important counterpart to that problem, is running a current account surplus of only about US$29 billion, and this is expected to narrow under the continuing influence of its accession to the World Trade Organisation. This is equivalent to 5% of the current account deficit of the US. Japan is running a much bigger current account surplus, amounting to US$134 billion and equivalent to 24% of the US current account deficit. The rest of "emerging Asia", interestingly with each of the nine economies running current account surpluses, together has a surplus of about US$110 billion, equivalent to 20% of the US deficit. The corresponding figures for the euro area are US$35 billion and 6% respectively.
From these figures, the intensity of the political pressures on the need for the Mainland of China sharing in the burden of resolving this "global external imbalance" seems disproportionately high. To be sure, the Mainland of China is running a bilateral trade surplus with the US that is more significant, but there is a need to take account of trade in services and other items in the current account. Furthermore, the particular focus on the renminbi exchange rate (and indeed the exchange rates of other currencies with limited flexibility, by design or through intervention) seems misplaced. There is an implicit assumption that exchange rate adjustments will always produce an improvement in the current account balance of payments - in other words, an appreciation (depreciation) in the exchange rate will reduce (increase) the balance of payments surplus. I have yet to see convincing empirical evidence of this relationship. It is true that an appreciation of the exchange rate makes domestic exports more expensive to the outside world and imports cheaper. But it is important to consider whether an exchange rate change will necessarily produce changes in the quantities of imports and exports to such an extent as to lead to the desired adjustment in the current account balance in money terms.
The point can be illustrated by a simple example. Assuming that a country running a current account surplus (taking it to be the trade surplus) of $100 billion (in its domestic currency), being the difference between exports of $1,100 billion and imports of $1,000 billion. The country appreciates its exchange rate by 10% with the intention of reducing that surplus. The appreciation indeed leads to cheaper imports, but the increase in the quantity of imports is only 2% because no matter how cheap rice is we eat only one bowl a meal. The import bill, in domestic currency terms, becomes $918 billion ($1,000 billion x 0.9 x 1.02). It also leads to exports being more expensive to the rest of the world and the quantity of exports falls by 5%. Export receipt, also in domestic currency terms, becomes $1,045 billion ($1,100 billion x 0.95). The trade surplus, as a result of an exchange rate appreciation of 10%, instead of falling, rises by 27% from $100 billion to $127 billion.
Economists should be familiar with this simple illustration, which we come across in explanations of the Marshall-Lerner condition. We should, however, note that this is a partial analysis, and that other factors also come into play. In addressing this problem of the global external imbalance, particularly when focusing on possible exchange rate adjustments as a policy response to the problem, it is necessary first of all to be clear about the magnitude of the import-demand elasticities. But this is something that is quite uncertain. In the case of Japan, has the appreciation of the yen led to a reduction of the current account surplus? The answer is no. Of course the import-demand elasticities are country-specific, since each country has its comparative advantage in the production of different products, so that the experience of one may not be applicable to another. But at least we should not just assume that exchange rate adjustments are the panacea. Perhaps it is politics rather than economics that are behind all this.
Joseph Yam
26 February 2004
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