Nouriel Roubini's Global EconoMonitor

RGE Monitor – Navigating Towards Bretton Woods 3?

A few years back, before this crisis erupted, several economists were concerned about the sustainability of the large global imbalances fueled by the so-called Bretton Woods 2 (BW2) system. These economists recognized in the tendency of emerging (export-led) economies to manage their exchange rate systems the origin of large trade and current account surpluses that, via large foreign reserve accumulation, were financing the mirror of those surpluses, namely the large U.S. trade and current account deficits. These surpluses, primarily in several exports-led Asian economies, and also in oil producing countries, ballooned to extensive proportions in 2007 and 2008. The purchases of U.S. government bonds by these investors helped keep long-term interest rates low and led many investors to seek out high-yielding investments especially in some emerging markets.

Although we are not (yet) witnessing a U.S. dollar crisis, the Bretton Woods 2 system is still at the center of the debates on the origins of this crisis. Understanding the nature of this crisis is fundamental in order to understand what reforms need to be undertaken for this not to happen again, and to understand what the global economy will look like after this crisis. Although other factors played a part, it is hard to argue that the large global imbalances that arose a few years ago had no role whatsoever in the current global synchronized recession. However, so far, global imbalances do not seem to be on even the long-term agenda of most of those trying to remake the global financial system.

Global imbalances are now starting to narrow though – and the current crisis is likely playing a role – as saving rates rise in the U.S. trade volumes fall on lower demand, expensive credit and weak commodity prices. The U.S. current account deficit has fallen from 6.6% at the end of 2005 to 3.7% at the end of 2008 and the IMF estimates that it will fall further to 2.8% of GDP in 2009. Many of the emerging economies that easily financed wide deficits are now being forced into consuming less given the lack of credit and in some cases currency devaluation that boosts the costs of imports. Meanwhile the fall in the price of oil and other commodities is shifting many oil exporters, some of the larger surplus nations, into deficit territory.

Is this the death of BWII‌ Can export-led growth countries increase consumption‌ Or are we going to see large imbalances in the global economy come back when the recovery will be in full swing‌ And would a permanent correction of global imbalances be contractionary‌ If surplus economies continue along a business as usual path, trying to stoke export demand rather than increasing domestic spending to boost consumption, it could increase deflationary pressures.

Fiscal and current account surpluses and foreign exchange reserves can be used to increase government spending on infrastructure and public services and boost consumption and investment, which might help unwind the global imbalances. In fact, fiscal stimulus spending being undertaken during the current downturn by surplus countries like China and the Middle-East will help increase their own domestic demand and also boost the exports of deficit countries. Governments with comfortable fiscal/external surpluses, commodity revenues or foreign exchange reserves, such the Asia-Pacific, GCC and Latam economies, Canada, Norway, Germany and Russia, have rightly increased stimulus spending in spite of easing exports and commodity prices recently. However, there are criticisms that such spending still fall short and are rather steered towards export firms than domestic demand which will only exacerbate global deflationary pressures. On the other hand, stimulus spending by deficit countries such as the U.S. and UK will only accentuate pressure on global fiscal deficits and global imbalances.

Some are still concerned that the unwinding of imbalances might be disorderly leading to swift exchange rate moves. However, it is also possible that this might be a gradual process, aided by a beefed-up IMF and other multilateral institutions which will avert balance of payments crises if not sharp contractions in many emerging economies especially in Eastern Europe.

Some imbalances seem to be persistent though. China’s surplus does not seem to be shrinking very much, largely because the import contraction including goods for re-export and cheaper commodities is more severe than that of exports. And those of Germany and Japan are expected to continue to be quite large also.

The consumption share of China’s GDP has fallen since the year 2000 although Chinese government investment could provide a boost in 2009. The IMF suggests that China’s current account surplus will continue to rise- albeit at a slower pace – in 2009, nearing $500 billion from almost $430 billion in 2008. Such a large current account surplus implies still large reciprocal deficits in some of China’s trading partners, likely the U.S. and several European countries.

As we noted in our recently released outlook, there is a risk that China’s fiscal stimulus might exacerbate production overcapacities, creating further deflationary pressures unless China is able to stimulate domestic demand, especially private consumption. Moreover, there is related risk that China’s extension of investment and credit expansion could defer China’s transition to a global economy in which the U.S. consumer consumes less. As it currently stands, China’s almost $600 billion fiscal stimulus has less than 10% dedicated to social welfare programs. Expanding this expenditure through increasing government expenditure on health care, increasing pension payments and unemployment benefits, could have a significant effect on boosting consumption particularly as it could reduce some of the households’ structural pressures to save. In the longer term, some tax policy changes, including the requirement of state owned enterprises to pay dividends and introduction of a value added tax, might also be supportive of consumption based growth. As detailed in Nouriel Roubini’s account of his trip to China, Chinese leaders are cognizant of the need to rebalance growth, meaning China may be better placed to do so than some of the export and investment-led advanced economies or the Asian tigers whose growth models are in question in the midst of the global export collapse.

So far, despite several months of hot money capital outflows, China seems to have increased its share of the safest U.S. assets especially treasury bills. Given the global export weakness, China may be forced to maintain its quasi dollar peg, which will likely involve a resumption of U.S. dollar asset purchases. Yet, Chinese concerns about the long-term value of its U.S. assets have increased. China has been diversifying its assets on the margins, increasing the share of gold (from a very low share of total assets) and loaning its foreign exchange to resource exporters. The Chinese central bank governor has suggested that over time the IMF’s SDR has a certain attraction as a reserve currency given the instabilities that have stemmed from the U.S. dollar’s reserve currency role. Take a look at: Will China Keep Buying U.S. Assets‌ Shifting to Short-term Liquid Assets and Can Chinese Growth Really Be Driven By Consumption‌

The severe impact of the global recession and export contraction on Asia’s growth and manufacturing output and employment loss might pave way for Asia to re-think its export-led growth model and change its source of growth away from exports towards domestic consumption. However, this might require a lot more political will since this growth model has nevertheless helped Asia attain higher per capita income, stronger economic growth and significant poverty reduction. Moreover, the structural changes required to change the growth model (move production from low-end manufacturing to high-end labor-intensive manufacturing and services to boost employment and incomes, improve social safety net, pension and health care systems, invest in skill training and R&D, and enhance intermediation of savings and credit access for firms by developing financial markets) all involve short-term costs with results only in the long-term, something that political leaders might be unwilling to trade. [See Box 1 – Can Asia Move From an Export-Led to Domestic Demand-Led Growth Model‌inRGE Monitor’sQ1 Update to the 2009 Global Economic Outlook.] On the other hand, it might be argued that Asia might continue to follow an export-led model even in the future to sustain growth and poverty reduction and at the same time use the presently available vast resources to boost safety net and cushion the economy and workers from any future global export downturn.

While policies to increase domestic demand might boost Asian imports and reduce current account surpluses, shrinking exports recently have in fact led imports to shrink at a faster pace than exports (given high import content of exports) thus keeping up the trade and current account surpluses in many Asian countries. Letting the exchange rate appreciate will also be challenging for Asia and will largely depend on China’s currency stance. In fact, many Asian countries started favoring an undervalued currency or at least stopped allowing appreciation recently as exports weakened and to maintain competitiveness vis-a-vis China. Asia’ stance will also be governed by the losses that the central banks will have to realize on their U.S. treasury holdings by letting their currencies appreciate. Moreover, any change in Asia’s growth model will be governed by the medium to long-term factors such as the pace of rise in the U.S. savings rate and whether it’s structural or cyclical in nature, and also the trends in global commodity, shipping and Asian labor costs going forward.

It is a different story with commodity exporters who as a whole are set to shift from surplus to deficit territory in 2009 given robust spending and much lower revenues. Unlike China, oil exporters were already contributing more to rebalancing in the last few years, with much of the incremental increase in revenues being spent or rather absorbed at home by massive projects and increased consumption. In fact, rather than generating surpluses, the current risks are that the economies of many oil exporters in the CIS, Africa and even some in the GCC could contract in 2009 on given the weaker hydrocarbon and non-hydrocarbon sector outlook.

Facilitated by past savings, many of these countries including Saudi Arabia, the UAE and Russia are conducting expansionary fiscal policies this year and will run significant fiscal deficits at an oil price below $50 a barrel. Moreover countries like the UAE, Saudi Arabia and others are expected to run current account deficits, financed by the sale of past savings. Meanwhile with many sovereign wealth funds and other government capital been deployed at home, there may be fewer foreign purchases. See Will Petrostates Have to Scale Back their Spending Sprees‌

The eurozone’s largely balanced external position covers ample intra-EMU imbalances among eurozone countries. Current account dispersion reached from +8.4% in the Netherlands and 7% in Germany to –13.4% in Cyprus as of 2008. The European Commission notes that while large current account balances by themselves could merely be the expression of rational private sector choices, a comparison of real exchange rates (REER) with their benchmark “equilibrium” current accounts shows the existence of sizable real exchange rate misalignments. See Adjustment in EMU: Are Stabilizing or Diverging Forces At Work‌

Decompositions of this kind gave rise to claims that Germany, in particular in its role as EMU’s ‘center’ economy, is engaging in beggar-thy-neighbor behavior by setting in motion a real competitive devaluation of its currency through falling unit labor costs. This makes a rebalancing of high deficit countries all the more challenging. Since a nominal devaluation is not an option within the EMU, high-deficit countries have no option but to deflate in real terms either through relatively higher productivity or consumption restraint against an already ambitious German benchmark. Take a look at: Spain Running A Current Account Deficit of 10% of GDP: Is a Sudden Stop A Real Possibility‌ And The Credit Crunch In the Eurozone: Is The Corporate Sector The Eurozone’s Weak Spot‌

As reported in RGE’s Global Economic Outlook (January 2009), Germany is not exposed to over-indebted households and non-financial corporates to the same extent as Spain, Ireland or even France. However, as the current downturn makes painfully clear, balanced financial accounts provide no shield against an over-reliance on external conditions or undiversified specialization patterns. Bundesbank president Axel Weber recently made clear that Germany should try to break its dependence on exports as the mainstay of its economic growth, whereas Chancellor Angela Merkel argues that a strong industrial base and external competitiveness are valuable assets, especially for an ageing and shrinking population. In fact, “[export-reliance] is not something we even want to change.” Check out: Germany As Export Champion: Sign of Strength or Sign of Weakness‌

Ultimately, the BW2 system of global imbalances has had far-reaching effects beyond the U.S. and Asia. Like the U.S., emerging markets in Eastern Europe were able to fund large current-account deficits in the recent era of cheap financing. In May 2007, Nouriel Roubini wrote: “The currency and economic policies of China and East Asia have contributed – among many other factors – to unsustainable global current account imbalances whose rebalancing now risks becoming disorderly rather than orderly.” This is certainly the case in Central and Eastern Europe (CEE), where current account deficits have been the norm and where the unwinding of such imbalances is raising concern that it could contribute to a regional financial crisis along the lines of 1997 in Asia.

The drying-up of capital inflows, amid the global financial turmoil, is necessitating a sharp adjustment in Eastern Europe’s external imbalances. These imbalances rival, and in some cases exceed, those in pre-crisis Asia – i.e. current account deficits in Southeast Asia from 1995-97 fell within the 3.0-8.5% of GDP range, while those in CEE were well over 10% of GDP in Romania, Bulgaria and the Baltics in 2008. A correction in the region’s imbalances is already underway via currency depreciation (in countries with flexible exchange rates) and via a sharp drop in domestic demand. Thus far, the IMF has stepped in with financial assistance in three EU newcomers – Hungary, Latvia and Romania – to smooth out the sharp drop-off in capital inflows and to avert a disorderly unwinding of external imbalances. These countries are unlikely to be the last to knock on the IMF’s door.

6 Responses to “RGE Monitor – Navigating Towards Bretton Woods 3?”

GuestApril 29th, 2009 at 5:46 pm

It not hard to argue that “the large global imbalances that arose a few years ago had no role whatsoever in the current global synchronized recession” see BRETTON WOODS II STILL DEFINES THE INTERNATIONAL MONETARY SYSTEM, NBER Working Paper 14731 February 2009.

GuestApril 29th, 2009 at 6:24 pm

“and the current crisis is likely playing a role – as saving rates rise in the U.S. trade volumes fall on lower demand, expensive credit and weak commodity prices. The U.S. current”If you think savings are going to rebalance anything, you haven’t looked at the data. As incomes shrink and debt burden increases, what exactly are they supposed to save?Please stop looking at the green shoots. You can’t see the forest for the green shoots. Grow up.As for the rest of this entry, it’s blah blah blah irrelevant academicspeak.John Ryskamp

MAMay 4th, 2009 at 3:24 pm

Your persistence is impressive John.Will you tone down the rhetoric and insults enough to stick around??? (History says “I DOUBT IT”)I’d almost be interested in your views (even if severely contrarian to mine) if you were able to contain them without going into a rant, hijacking of the blog, or promotion of your book or some other serving interest.If you are indeed back (or if just sneaking past the gates of your “ban from the RGE”) please try to keep it together.Miss America

JRTApril 29th, 2009 at 11:30 pm

Stop calling it Bretton Woods II. The name implies a “system” to the uninformed.BWI was a set of policies agreed upon between the major players (a rudimentary set of rules defining a “system”). There are no agreements in BWII despite a fundamental requirement of floating exchange rates as the feedback mechanism to adjust imbalances. China, OPEC etc. are pegging so there is no “system”. Even worse, China maintains capital controls over internal and external exchange (Renmimbi/Yuan).What we have is a collection of individual state policies driven by self interest (some mercantile) with policies changing to optimize each players relevant planning horizon. We don’t worry about current account imbalances between states in the US because labor and other mobilities can balance this out. These business time constants are too slow (and usually nonexistent) across international boundaries.We’re flunking an IQ test if we think there is any automatic rebalancing. This “system” is designed to go to extremes and then break…huh seems to be performing exactly as expected.Call it the un-cola.

PhilTApril 29th, 2009 at 11:52 pm

Perhaps a different title would better suit the content of this article … maybe something like A current view of BW2.It would really be nice to read the RGE insights on a post BW2 realm.

g AntonMay 5th, 2009 at 2:37 pm

The “end” VS The “END”–Bernanke’s Wet DreamBen Bernanke has informed us (via the US Congress) that the “end” is near. By this, he means that the US economic growth (i.e. US consumer comsumption) will go positive by the end of the current year. I don’t think he’s right, but my only reason for thinking this is that he’s usually wrong (do you remember his famous assurance in October of 2005 when Ben told the congress that they didn’t have to worry about the housing bubble busting because the increases in housing prices was based on “very strong economic fundamentals”?).But let us assume that he is right this time (I realize that making this assumpion requires quite a bit of imagination). The implication is that all our economic problems will be over–the Dow and the GDP will soar off into the stratosphere, the US consumer will merrily consume away, there will be cheap gasoline and oil for all, company profits will be obscenely profuse, etc., etc., and China will foot the bill! All hail the status quo ante!I don’t think so. The pre-crisis world economy was metastable and unsustainable, and the post-crisis economy (if there is such an animal) will be even less sustainable.What I refer to as the “END” is when our current financial world comes apart (and it will be very difficult to put it back together again). Personally, I believe that this is inevitable and will happen sooner than Ben thinks. I also think that it will not be the result of a single catastrophic event, but the result of a long, painful, and drawn out process. As the great poet said, “The world will not end in a bang, but in a whimper”.