The Financial Rebalancing Act

The global financial crisis that began in 2007 has only just begun to recede, but economists and policymakers are already considering its future implications. Has the Great Recession introduced a new economic era? Or was it a temporary shock that will eventually correct itself? The answers to these questions will affect a number of vital economic issues, including the relationship between emerging and developed economies, the direction of international trade and capital flows, and the potential for currency wars or other economic conflicts.

Both the recent crisis and the policies that ended it were unprecedented. Compared to other periods of economic turmoil, this crisis was not only unparalleled in scale but also unique in its causes -- among them, many argue, global financial imbalances. Basic economic theory presumes that capital will flow "downhill" from capital-rich developed economies to capital-scarce emerging ones, as investors in the first seek profits in the second. Yet over the past 15 years, capital has, on net, flowed "uphill" from emerging economies to developed ones. Although private capital did travel downhill, as conventional wisdom predicts, it was offset by vast government reserves from emerging countries, chiefly from central banks and sovereign wealth funds, heading uphill. When the recession struck, this unprecedented flow of capital and accumulated reserves suddenly seemed less of a mystery, as emerging markets facing problems began to use the reserves they had accumulated to ride out the economic storm. With that insurance on hand, they defended their currencies, averted capital flight, buffered their financial systems, maintained access to capital markets, and pursued fiscal stimulus programs more successfully than they had during previous episodes of economic turmoil and with greater confidence than some of the developed economies.

Yet although these global imbalances may have helped emerging economies during the financial crisis, many have argued that they also contributed to fueling the financial crisis among developed markets in the first place. The International Monetary Fund (IMF) and the G-20, along with many central banks, finance ministers, and economists, have argued that this "savings glut," in the words of U.S. Federal Reserve Chair Ben Bernanke, was a key factor in directing capital toward rich countries, lowering real interest rates, and encouraging excessive risk taking by households and investors. Leaders throughout the world have devoted a great deal of energy to ending these global imbalances in the hope of preventing another crisis. U.S. Treasury Secretary Timothy Geithner, for example, proposed a cap last year that would limit capital flows. And the G-20 later attempted to devise a warning system of macroeconomic indicators to identify excessive imbalances.

Yet a closer look at both economic history and current trends suggests that even without government intervention, these global imbalances are likely to stop increasing at the same pace and may even decrease. And so, by doggedly emphasizing the importance of these imbalances, economists and policymakers risk fighting the last battle even as a new postcrisis economy emerges with its own set of challenges.

CRISES, THEN AND NOW

To understand the capital imbalances that occurred during the Great Recession, it is helpful to compare the period that led up to the crisis to earlier cycles of globalization. In the first era of globalization (from approximately 1870 to 1914) both trade and financial flows expanded dramatically. Capital came mainly from Europe, especially from the United Kingdom, which largely channeled its investments into its colonies. British investors directed their money to rich settler countries, such as Australia and Canada, where it was used to develop natural resources. Many of the poorer emerging markets of the day were part of some European state's empire, meaning that they presented few sovereign risks and investors could expect to find virtually identical legal and institutional support there as what they knew from home. Although in the one region where investment was risky, the independent states of Latin America, investors often experienced recurrent defaults, banking crises, and currency crashes, capital basically flowed from the rich core to the poor periphery in the lead-up to World War I.

But then, the first era of globalization fell victim to all-out war, the Great Depression, and war again. By 1945, most countries had retreated behind trade barriers and capital controls. The 1944 Bretton Woods conference, convened to rebuild the international economic system, established a global financial order that led to the creation of the IMF and, eventually, the World Bank. Under the Bretton Woods system, a sense of calm settled on global markets, with no financial crises occurring throughout the 1950s and 1960s. Although the cause of this tranquility is still debated, two features of the Bretton Woods regime undoubtedly contributed. Under the Bretton Woods fixed-exchange-rate system, governments could tightly control external flows of capital to prevent the flight of money and avert speculative attacks on their currencies. And strict, even draconian, restrictions on domestic financial systems kept banks constrained, forbidding them from taking large risks and moderating their ability to leverage.

Yet the Bretton Woods system withered away in the 1970s and 1980s, undercut by financial innovations designed to evade capital controls, a lack of commitment to fixed exchange rates, and a willingness of governments, especially in the developed economies, to tolerate greater financial freedom at home and abroad. As a result, a more freewheeling system of finance arose, similar to that of the first era of globalization. This occurred first, in the 1980s, among developed markets and then, in the 1990s, among emerging markets as they opened up their economies and began to embrace financial globalization.

Financial crises then began reemerging. They did not immediately impact the seemingly resilient developed economies. Various crises in developed countries, from the widespread U.S. savings and loan failure in the 1980s to the collapse of Scandinavian banks in the early 1990s, were costly but not crippling. But the arrival in the emerging world of financial globalization, with its demands of political and institutional stability, financial supervision, and monetary and fiscal probity, proved far more damaging.

Emerging countries often experienced a double or triple crisis. A currency crash would weigh down banks and the government by magnifying the value of foreign hard-currency debts in local-currency terms, raising the risk of government default and banking crises. Or a bank collapse would injure the economy, triggering fiscal strains and capital flight and raising the risk of government default or currency crises. Additionally, a sovereign default would devastate banks' balance sheets and elevate the country's risk premium, raising the pressure for banking and currency crises. Any one of these types of crises was apt to trigger another.

Many emerging countries found themselves caught in this vicious cycle. The largest and most alarming wave came during the 1997-98 Asian financial crisis. Caused by a still-disputed combination of weakening macroeconomic conditions and self-fulfilling investor pessimism, the crisis shut down access to capital markets and led to widespread devaluations of currencies and credit crunches across South and East Asia, causing, in turn, stock-market declines and sharp recessions.

An agreement that Indonesia and the IMF struck in early 1998 was a defining moment of the crisis. Indonesian President Suharto was forced to accept a bailout from the IMF to avoid a default. In exchange, he had to comply with the IMF's demands for drastic economic reforms meant to prevent another crisis and achieve a sustainable outcome: reducing Indonesia's deficit, permitting the failure of insolvent firms and banks, and raising interest rates. The photograph of the signing of the agreement, showing Suharto hunched over papers with the IMF's managing director, Michel Camdessus, standing over his shoulder like a watchful schoolmaster, captured the humiliation of Indonesia and other states that had been struck by the crisis and were now forced to rely on Western aid and bow to stiff conditions. In the years that followed, emerging economies would take steps to avoid such dependence on foreign assistance. Outside help was to give way to self-help.

THE $12 TRILLION-STEP PROGRAM

Around 1990, global central-bank reserves totaled approximately $200 billion. By 2009, that number had climbed to about $8 trillion, and sovereign wealth funds accounted for as much as another $4 trillion. In other words, a remarkable $12 trillion was being hoarded for a hypothetical disaster. The emergence of these massive war chests is arguably the most important story of the global economy over the last two decades. And it is almost entirely the making of emerging-market economies, among them, Brazil, Chile, China, Russia, and Singapore, which increased their reserves from four percent of their GDPs in 1997 to 27 percent in 2007. Emerging markets had learned to save up wealth for rainy-day funds, creating for themselves a means of financial adjustment that they could control in times of stress -- unlike the strategy of relying on the IMF or other foreign powers.

Yet this self-insurance did not come cheap. Critics in emerging economies and abroad worried that such plans to save for later rather than spend now would result in unjustified opportunity costs, such as lost investment opportunities, lower consumption and social spending, and low interest rates on U.S. Treasury securities. These concerns magnified as the reserves grew from hundreds of billions of dollars to trillions from the 1990s to the early years of this century.

Costly or not, however, the emerging markets' insurance strategy has wildly exceeded expectations. These economies hardly suffered during the recent crisis, as they were able to use their vast reserves to bulwark currencies, prevent capital flight, and pay for fiscal stimulus programs. Chile, under the guidance of then Finance Minister Andrés Velasco, typified this resilience. Criticized during the boom years for setting aside revenues from sales of copper, Velasco was later cheered when he drew on those reserves to stimulate spending and cut taxes, thereby stabilizing the economy. His approval ratings surged from around 30 percent before the crisis to around 70 percent afterward, demonstrating that voters understood and appreciated the insurance strategy as much as economists and policymakers.

TOO MUCH OF A GOOD THING?

The success of emerging markets in withstanding the brunt of the financial crisis counts as an enormous victory for the reserve-accumulation strategy. But is this strategy good for all countries, and how far should it be taken? If reserves are to continue insulating economies against financial risk, their levels may need to keep pace with GDP growth.

Yet by doing so well during the recent financial crisis, many emerging economies have demonstrated that they have, or are close to having, sufficient levels of reserve funds to guard against potential disruptions. To be sure, these reserves may not permanently protect them, and so governments must remain vigilant. But they have unquestionably made emerging markets much safer than they were ten or 20 years ago, when they had far fewer reserves, especially given the low costs involved in accruing such reserves compared to suffering a financial crisis. Now that they have built safer levels of external wealth, emerging markets may feel less pressure to keep piling up reserves. This may mean that the world economy will soon enter a new and unprecedented phase of rebalancing, as adjustments to the patterns of investment, saving, and capital flows take effect.

As in past eras of structural transformation, the emerging economies are growing faster than the developed ones, powered by their desire to achieve parity with developed countries in technology, industry, and living standards. The emerging countries' share of world output in goods and services is already nearing 50 percent, and since before the onset of the recent economic crisis, the gap between their growth rates and those of developed markets has become wider than ever (between five percent and seven percent per year since 2006). This shift will inexorably raise global investment demand since emerging markets traditionally engage in high levels of investment.

In addition, the supply of global savings will likely decline. Aging demographics in developed countries will likely depress savings, even though governments may flirt with fiscal austerity and households may try to reduce their debt. In the emerging world, the accumulation of reserves will likely taper off, allowing resources to be diverted toward other needs, such as spending on investment, boosting consumption, and building social safety nets. Reserve holdings may not fall in absolute terms, but the pace of hoarding may slow. For capital markets to reach equilibrium given these shifts, global real interest rates will have to rise worldwide; otherwise, investment will exceed the supply of savings. The era of a so-called savings glut will thus end, and the impetus for capital to move downhill from developed countries to emerging ones will strengthen.

Finally, adjustments among emerging countries will require the surpluses of emerging markets to fall or even reverse on net. But as history shows, such shifts from surpluses to deficits are accompanied by stronger currencies in real terms. To run current account surpluses, emerging markets have had weaker currencies for years. As these imbalances correct themselves, emerging economies' currencies will tend to strengthen in real terms one way or another, either as local prices rise or as currencies appreciate relative to developed markets. A new era with less capital flowing uphill and stronger emerging currencies is therefore within the realm of possibility. But when and how can it happen?

There are signs that this process of correction is already under way. Emerging-market currencies began strengthening against the U.S. dollar around 2004-5, approximately when China loosened its currency's peg to the U.S. dollar, and the trend was only briefly interrupted by the subsequent financial crisis. Now, this trend is continuing and perhaps even accelerating. As they emerge from the financial crisis, emerging countries face a stark policy choice in terms of how to approach real appreciation: raise interests rates and let their currencies appreciate or else continue to fix their currencies and risk importing inflation. Short-term pressures -- reflationary cyclical rebounds; larger-than-average differentials in productivity growth; and idiosyncratic commodity price shocks affecting oil, food, and key imports -- are pushing policymakers from emerging countries to consider allowing their currencies to appreciate.

Yet this transition to global rebalancing cannot be taken for granted, and a supportive policy environment in both the developed and the emerging worlds will greatly influence its course. In particular, the shift toward currency appreciation will prove easier if it is led by China. Although China, a key potential leader in this process, is gradually allowing the yuan to appreciate, Chinese Vice Premier Wang Qishan admitted in May that the "biggest challenge" for Beijing was to reach internal consensus on rebalancing China's economy, a process that will slow appreciation. In those countries where appreciation has advanced, such as Brazil, the discomfort felt at having moved first as other countries retain the trade advantage of a weak currency has stoked anxieties about currency wars.

Even if it appears to be doing so too cautiously and too reluctantly for some of its critics, however, China seems to be moving toward aiding a global rebalancing. Its new five-year plan, which it announced earlier this year, calls for the country to bolster welfare programs, develop domestic demand in order to drive growth, and raise internal consumption and investment. Perhaps the strongest sign of change came from the governor of the People's Bank of China, Zhou Xiaochuan, who announced in April that China's reserves "exceed [the country's] reasonable requirements." That same month, Chinese Premier Wen Jiabao declared that he would "strengthen the flexibility" of the yuan's exchange rate to control inflation. Should Beijing pursue this path, other, smaller emerging-market nations might more easily follow the same route: they could allow their currencies to strengthen without the fear of damaging their competitiveness with China since China has already made the first move in the rebalancing game.

THE IMBALANCE DISTRACTION

Beyond the Great Recession and the recovery, long-term trends support the idea that a rebalancing is under way. A broad range of economic figures suggest that emerging markets are catching up to developed markets. As the Great Recession fades, this trend is likely to continue. The emerging-market history of low growth and high volatility is fading, while developed markets are experiencing more instability and financial impairments. Emerging markets have decreased their debt-to-GDP ratios, even as developed markets, including the United States and some in Europe, are letting theirs rise. In a sign of convergence between emerging and developed markets, health and schooling levels in emerging-market countries are now comparable to those seen in developed markets around 1975, with the gap continuing to narrow. And average levels of political and economic freedom in emerging markets have also dramatically improved in the last two decades. Although emerging markets have not yet achieved parity with developed markets -- income inequality has deepened in emerging markets even more rapidly than in developed ones in recent years, and emerging markets must still improve their political and economic freedoms -- they now appear more stable and better positioned to enjoy sustained growth than they did a generation ago.

If policymakers can reinforce these trends, enhancing the emerging world's growth prospects, they will round out the decade or two of adjustments set in motion by the once-in-history opening of emerging markets to economic and financial globalization. The imbalances of the recent era of globalization represented a specific response to a peculiar set of historical circumstances, as emerging markets learned to navigate a fragile financial landscape. These imbalances have begun and will continue to even out through patience and gradual shifts in market mechanisms and policy.

Even as the threat of global imbalances fades, the next phase of globalization will present new risks and opportunities that policymakers will need to confront. Developed markets could remain lethargic or suffer further slumps, increasing the risk of a global downturn. Financial stabilization policies may not be implemented effectively and evenly enough to avert the risk of another global financial crisis. Net capital flows could reverse and drain investment away from developed countries, potentially triggering protectionism. Inequality trends could persist or even widen. As the Doha Round limps along, the open trading environment built over the last 65 years could face rising pressure. Political and economic reforms across the world may stall, halting or reversing recent progress.

By devoting time, energy, and political capital to correcting today's perceived imbalance problem rather than tackling the challenges on the horizon, world leaders risk fighting the last war. It may be not just the global economy that needs some rebalancing but also policymaking itself.