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Global Imbalances, Reserve Management and Public Infrastructure in India

If there were no policy interventions of any kind in the foreign exchange markets, and all markets were present and deep, it is far from clear that the size and direction of global imbalances would be any different than they are today. What would be different is the manner in which surplus savings are being managed. The real problem today is not a macroeconomic one to be alleviated by a complex policy coordination of monetary and fiscal policies. Instead, it is a microeconomic problem of how to best manage national savings.

Banking Policy Issues

Global Imbalances, Reserve Management and Public Infrastructure in India

Hare creatures of fashion. Recent fashions have included central bank independence, the “two-corner-solution” in

Economic and Political WeeklyMarch 31, 20071103Less than half of these top 10 surpluses are in emerging econo-mies, less than half are in “Asian countries” and less than halfare in countries that follow a fixed or semi-fixed exchange ratewith the dollar. Consequently, characterising this constellationof a single deficit surrounding by a great many surpluses as “Asiansurpluses” as many routinely do, or the result of “Chinese exchangerate manipulation” as some do, seems to owe more to domesticUS politics than financial facts.It is a sad reflection of the current state of the internationalfinancial system that the debate on US deficits is so politicised.It is useful to remember that one of the underlying motives thatlay behind John Maynard Keynes’ proposals in the summer of1941, for an international fund, bank and trade organisation, wasto de-politicise international economic relations.4 From the 1930,Smoot-Hawley Tariff Act, to its retaliatory responses, such asthe 1931 devaluation of Sterling and the 1933 Ottawa Agree-ments, Keynes witnessed at first hand the ill-effects of the pursuitof national or narrower political interests in the conduct ofinternational economic and trade policy.Today’s attempt by the US Congress to blackmail China, withthe threat of punitive tariffs if they do not revalue their exchangerate, is therefore a highly dangerous precedent for all.5 Indianofficials cannot allow themselves any schadenfreude at the expenseof their one-time foe. India could easily be the next target. Afterall, despite all the focus on China, no mainstream macroeconomicmodel indicates that a revaluation of the renimbi of the size beingcalled for in Congress (e g, 25-40 per cent) would severely dentglobal imbalances; and while China’s current account surplusas a per cent of its national GDP is now substantial (7 per cent),in global terms, its cumulative surpluses are neither the largestor fastest growing. Japan has the largest cumulative currentaccount surplus over the past three, five and ten years. SaudiArabia has seen the most dramatic turnaround in its currentaccount position in recent years. Yet, Japan and Saudi Arabia,political allies of the US, are never cast in the same light as China.It goes without saying that the willingness of voters in emergingmarket economies to support an opening of trade and capitalaccounts will be impaired, with welfare losses for everyone, ifthey believe that the winners and losers of the internationaleconomic system are determined by whatever happens to go downwell in the living rooms of Ward 62 in Columbus, Ohio.6Macroeconomics of Global Imbalances andWhy Exchange Rate Flexibility Is Not a RemedyThe essential point of Keynes was that the more politicisedtrade and financial relationships are, the less good policy out-comes will be for all. In the section above we argue that thepressure for China to shoulder the greatest part of global economicadjustment to international imbalances owes more to base politicsthan sound economics. Politics is often more fluid than economicsand so it is possible that the focus of US politicians couldwiden from China to include India and other countries. In thissection, we look beyond China at the prescription of a revaluationof exchange rates in general, as a response to global imbalances.It is understandable for the National Association of USManufacturers to pursue protectionism by lobbying for revalu-ations of the currencies of their main competitors. Europeanexporters would also clearly prefer an Asian revaluation to adollar devaluation. It is understandable too, that US voters,residingin a large, relatively insulated economy, where exchange ratevolatility poses few economic risks, view exchange rate flexibi-lity as the norm, and fixity as artificial at best and a nasty formof foreign socialism at worse. However, the idea that exchangerate flexibility is the correct response to global imbalances restson three fundamentally mistaken notions. Mistaken notions thatthe economics profession has been surprisingly slow to correct.Adjustment Occurs Under Fixed Exchange Rates TooThe first mistaken notion is that fixed exchange rates are anobstacle to dealing with imbalances of international payments.Economic adjustment to shifts in competitiveness occurs equallywell under fixed or floating exchange rates. In the case of fixedexchange rates, an unduly competitive exchange rate that gen-erates trade surpluses will lead to rising domestic prices, and asa result, a real exchange rate appreciation. Over time a nominalexchange rate that is “out-of-line” with competitiveness auto-matically moves back “in-line” through relative changes indomestic price levels.This form of adjustment is preferable for small, open, emergingeconomies where the volatility often attached to nominal exchangerate flexibility can be destabilising. There is more real exchangerate stability under fixed exchange rates than under floating forsmall states. It is argued, for example, that Germany enteredthe Economic and Monetary Union (EMU) in 1999 with a relativelyovervalued exchange rate. But since then its price level has fallenrelative to those elsewhere. Today, Germany is the world’s largestexporter and boasts the largest trade surplus in Europe.It should be clear, therefore, that a country cannot manipulateits exchange rate for gain, merely by fixing it at an “under-valued”level and holding it there for a long time. Indeed, the longer afixed rate holds, the smaller any initial competitive boost be-comes. In Germany’s case it took just four years for the initialcompetitive disadvantage to be removed. This is an importantobservation because while China is commonly accused ofmanipulation, it devalued its exchange rate in 1994 and held itfixed for 10 years before political pressure led to a move to gradualrevaluation from July 2005. A country could try to short-circuit the adjustment to a com-petitive and fixed exchange rate by pursuing, additionally, amonetary policy designed to repress domestic spending belowpotential so that the export sector could grow at the expense ofthe rest of the economy. Whether China had an overly tightmonetary policy during the last decade is shaping up to be oneof those great monetary debates alongside whether monetarypolicy was too tight in the US in the 1930s, or in the UK in the1980s. The issue will turn on what happened to agriculturalproductivity and financial innovation. But whatever the outcomeof that debate, the intention of policy is clear. The Chineseauthorities set monetary growth to accommodate their targetgrowth rates, and while these income targets are hit with anaccuracy that would make many a CFO blush, they are not un-ambitious. The appearance of pockets of overheating, a seriousproblem of imprudent lending in the domestic banking systemand a growth target of 10 per cent, does not smack of a deliberateattempt to curb domestic spending below potential.Of course, if the problem of global imbalances is caused byan overly tight Chinese monetary policy, which, under a fixedexchange rate, is crowding in exports, then the appropriatesolution is to loosen monetary policy; not to abandon the ex-change rate anchor. A measure of the inappropriateness of the
Economic and Political WeeklyMarch 31, 20071104move to greater exchange rate flexibility is that China still hasand requires substantial capital controls. (I am hard pressed torecall many other countries that have been urged to revalue, whilehaving capital controls imposed to guard against a devaluation.)Sterilisation Is a Vaccine for the Dutch DiseaseThe second mistaken notion is that where an exchange rateis managed, the correct response to a large improvement ofexternal payments is a revaluation. Unsurprisingly the correctresponse depends on the nature and likely duration of the balanceof payments change. This is well illustrated by the “Dutch disease”.This term was first used to describe the de-industrialisation ofthe non-traded part of the Dutch economy following the discoveryof natural gas off the coast of the Netherlands in the 1960s.7 Theessence of the problem is the different speed of reaction offinancial and goods markets. For our purposes it is well illustratedby the removal of one third of UK manufacturing capacity inthe early 1980s as a result of the appreciation in sterling followingthe discovery and production of North Sea oil and the dismantlingof capital controls.If an event causes a sudden revaluation of assets andexpectation of a future series of current account surpluses, thecapital market response is for an instantaneous capitalisationof this future stream of additional income, either through ajumpappreciation of the exchange rate or a large inward rushof capital, or where exchange rates are managed, a bit of both.However, because goods markets respond more slowly, theexchange rate change and concentrated capital flows makeithardfor that part of the economy that is not enjoying the boomto compete.The discovery and production of North Sea oil turned theUKoilbalance from a deficit of 1.8 per cent of GDP in the 1970sto a surplus of 1.6 per cent of GDP during 1980 to 1984. Thisimprovement of 3.4 per cent of GDP and its expectation, ledsterling’s effective exchange rate to appreciate by 20 per centbetween 1979 and 1981. This appreciation laid to wastelargewaste swathes of UK manufacturing capacity. By themid-1980s, the non-oil deficit, bloated by economic expansionand shrunken manufacturing capacity has grown to 4.5 per centof GDP.Foreign direct investment (FDI) and hot money inflows intoChina, amounting to over $100bn per annum, have an elementof “Dutch disease” about them. In recent years the world haswoken up to the potential of China. Corporations are pouringinvestment into China, not based on a track record of profit, buton the speculation that some combination of China’s past eco-nomic growth and current population size make it the opportunityof the century.This speculation can be seen in the rise in the Chinese stockmarket by 150 per cent in 2006 compared with a 20 per centrise in the world market. Share price/earnings ratios are generallylower in emerging markets than developed markets as investorsconsider the additional political and economic risks attached tothe growth path but recently Chinese price to earnings ratios haverisen above the developed country norm. China Mobile’s shareprice to earnings multiple is close to 27, for example, morethen twice that of Telefonica. There is much talk of a speculativebubble in the Chinese stock market. A large element of these FDIflows represent a “re-rating” of China in the capital markets andfirms, in effect, trying to “stake out the land” well ahead of anydevelopment. The speculation may be well-founded, but it isanother example of capital markets running ahead of the goodsmarkets. This experience and the pressures it has presented forChinese monetary and exchange rate policy are of particularrelevance to India now that inward portfolio and FDI flows toIndia are rising.The textbook way to avoid the Dutch disease is to sterilisetheboom revenues and so limit, or smooth, the impact on thereal exchange rate. By saving the boom revenues, a country issaving a current windfall for future generations. We shall returnto this topic later, but for now, examples of sovereign assetmanagers managing boom-time revenues include the ChileanPension Reserve Fund, the Government Pension Fund inNorway,The Kuwait Investment Office, the State Oil Fund ofAzerbaijan and the Government of Singapore InvestmentCorporation(GIC).Given the attempt of west Asian oil exporters to broaden theireconomic exposure outside the energy sector, it is particularlyimportant for these and other commodity exporters to steriliserevenues from the current oil boom and to invest them for a futurewhen the oil runs out, or for the earlier possibility that the worldno longer relies upon oil for its energy needs. Of course, it isnever easy to obtain political support for deferred consumption,even in the more wealthy commodity exporters like Norway.Butthe turmoil in west Asian equity markets in the first halfof 2006 is a reminder that the capacity of emerging marketcountries to absorb large inflows is limited and over-investmentcan rapidly become as troublesome as under-investment. Lowabsorptive capacity is probably as good as any other definitionof an emerging market.Incidentally, this limited absorptive capacity means we shouldnot be too surprised if from time to time the most efficient outcomeis for emerging economies to invest their savings abroad. Somecommentators like to assume the “Dutch disease” story does notapply to China and brush away the west Asian and commodityexporters more generally as a special, narrow, case. But in factthe most rapid growth in national savings has come, not fromthe newly industrialised Asian economies but energy exporterswith little capacity to absorb large surpluses domestically. In thelast year alone oil exporters have amassed reserves of $ 500bncompared with just $ 284bn in Asian economies.8 Global im-balances have more to do with commodity prices than the levelof the renminbi.Exchange Rate Flexibility Does Not Remove CurrentAccount ImbalancesThe third mistaken notion is that current account imbalancesare the result of fixed exchange rates and so flexible exchangerates are the cure. Large current account imbalances can co-existwith exchange rate flexibility and a non-interventionistpolicy. This is because current accounts and the savings-investment imbalance are not just an accounting identity butare also a behavioural relationship. Today current accountpositionsare most often the endogenous response to a savings-investment imbalance. In a country with flexible exchangerates and non-intervention, and where the desire to save fallsbelowthe desire to invest at home, such as the US, savings willflow in from abroad (a capital account surplus) appreciatingtheexchange rate until there is an equal and opposite currentaccount deficit.
Economic and Political WeeklyMarch 31, 20071105Imagine a country where the desire to save exceeds the desireto invest for exogenous reasons. Perhaps there is a young populationand a rapidly growing economy, so that the younger, wealthycohorts are saving for the future and the older, poorer, cohortsare the ones who are dissaving. In these circumstances, forcingan appreciation of the exchange rate will not change the demo-graphics. So, there will still be a capital account deficit. But tobe left with a current account surplus after the exchange rate hasappreciated requires a recession in domestic spending that curbsimports. This is not a theoretical construct. It is a very similardynamic to the one experienced by Japan in the mid-1990s. Asharp overshooting of the yen, partly as a result of politicalpressure from US exporters, did little to curb the Japanese currentaccount surplus, but coincided with a substantial weakening ofJapanese consumption.Macro or Micro?One of the ways to cut through the politics of global imbalancesis to ask what would happen to these imbalances if we removedgovernment from the picture altogether: no intervention in themarkets, no capital controls or exchange rate fixes and deepfinancial markets everywhere. As the discussion above indicated,it is far from clear that global imbalances would be significantlysmaller. Let us look briefly at two groups, which represent thetwo largest components of the world’s surpluses, commodityexporters and Asian economies.Would commodity exporters generate less dollar savings fromtheir commodity sales under laissez faire? No, not in dollar terms.Would the desire to invest at home rise in dollar terms? No, itis more likely to fall. Commodity exporters tend to have smallnon-tradeable sectors, industries that are downstream fromcommodity extraction and import substitution industries. The lasttwo will be undermined by an exchange rate appreciation. Chileis an example of a major commodity exporter with a more diverseeconomy than many (copper represents 20 per cent of the Chileaneconomy while oil represents 80 per cent of the Saudi economy)and a flexible exchange rate. The Chilean peso has appreciatedby 15 per cent over the past two years but the current accountremains in large and the appreciation of the exchange rate hasput a drag on the non-copper sectors. This in the words of onecommentator, “Chile has its head in the oven and its feet in thefreezer”.9Would exchange rate flexibility and an open capital accountmake China and her neighbours save less and spend more? Carefulconsideration suggests that this is unlikely. Analysis of deve-lopments in access to Chinese health, education and social se-curity, along with demographic transitions, suggests that weshould expect Chinese saving rates to be high and to have risen.Previous overinvestment and recent changes in the bankingsystem designed to provide more discipline in investment de-cisions is likely to lead to a reduction in the desire to invest fromthe current heady rates of 40 per cent of GDP. China’s absorptivecapacity for investment is far higher than many west Asianeconomies, but at any point in time, it has a limit. Any exchangerate appreciation that harms the export sector is likely to furtherundermine investment opportunities.In China as elsewhere there will be times when investmentopportunities are not as good as they were before and that thebest use of local savings is to invest them abroad. It is why wehave an international financial system. Under free capitalmobilityahigh and rising savings rate, colliding with a periodof local investment exhaustion or over-investment should leadto large capital exports and a current account surplus. This iswhat we observe and should not fear.The currency implications are ambiguous for both groups ofcountries – depending on the causation, the capital outflows maydrive the currency lower or the trade surpluses may push it higher.If China and the west Asian countries were to completely removecapital controls today we would expect capital exports to surgeto such an extent – as the private sector scrambled to acquireexternal assets as a risk diversifier – that currencies would initiallydepreciate. It should be noted that if China’s current accountsurplus reflects a structural savings-investment imbalance thena revaluation of the renminbi will only cause a Chinese downturn[Genberg et al 2005]. Fiddling around with exchange rates amidstructural savings and investment imbalances is at best a wasteof time and at worse dangerous.Microeconomic Foundations ofProblem of Global ImbalancesThe big difference between what we observe today and whatwe would observe under laissez-faire, is not the size of thesavings-investment gap or even the level of the exchange rate.Instead, the main difference lies in who is managing nationalsavings and in what manner. In a world of free-capital mobilityand a desire to save more than to invest locally, we would expectto see the private sector investing long-term savings abroad. Iffrom time to time, and based on an assessment of investmentopportunities, the Chinese private sector invested a significantpart of China’s pension assets abroad, why would anyone object?The problem of global imbalances has been falsely diagnosedas a problem of size and direction of global savings, when insteadit is more a question of the sub-optimal investment of nationalsavings. The problem is micro not macro.In China today the private sector does not have long-termsavings institutions to perform the role of asset manager, so thepublic sector does the job. But while the public sector cantakethe place of the private sector in terms of the amount ofsavings being managed, its asset allocation is very different fromthe one a long-term investor would choose. We do not selectour central bankers and design their institutions for them to berisk takers. They are liquidity managers and they have beenrecycling savings as a liquidity manager would, in the most liquidinvestments with the highest credit quality. This is the wrongasset allocation for national savings intended for the benefit offuture generations.The Liquidity PremiumIn the UK there are retail investment instruments called “postalbonds” which offer a higher three month or six month depositratethan commercial banks, but only if you do not cash in theinstru-ment before its term expires. If you do, large penalties are paid.The difference in yield between the instant access depositrateand the postal bond deposit rate for the same maturity is theliquidity premium (in this example there is no difference in creditrisk between the two deposits and market risk is effectivelyzeroona deposit). The liquidity premium can be quite significant. Thesix month liquidity premium is often in excess of 0.50 per centper annum. The 10 or 20-year liquidity premium is far greater.
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