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January 21, 2008
Amol Agrawal +91 22 66177921 amol@idbigilts.com

Can subprime crisis help unwind the global imbalances?
There are many ways in which the sub-prime crisis is being analyzed. In this report, we explore the impact if the crisis from the global imbalances angle.

Global imbalances mean that the conditions in the world are not in tune with the economic fundamentals. The imbalances begin with few countries initially and when not corrected due to some external factors, not only becomes larger in size but also involves many other countries becoming global in nature. Imbalances are a part of any economic cycle and economists study and make policy recommendations on how to address these imbalances. However, when the imbalances assume a global stature, it is not easy to address these imbalances, as large number of countries are involved and it needs to be addressed by policymakers of the countries involved. To understand the imbalances there is a need to understand number of developments. However, Figure 1 provides a nice summary of the imbalances. Ideally, the current account balances of all the countries should add to zero (or near zero because of discrepancies in the data) and as we see in the figure it is the case for most countries. However, the direction of the trend changes substantially from 2000 onwards with industrial (developed) economies having huge current account deficit and the developing economies huge surpluses. This is not right for following reason. Current account balance is nothing but a mirror image of the investment and saving position in an economy. If investments are more than the savings, it is expected that the country would have current account deficits and vice versa. In order to finance the current account deficits the economy would have to invite capital flows from abroad. It should also be expected that it is the developing economies that would have higher investment levels and should be borrowing from abroad. However, what is seen is the opposite and it is the developed economies that get have the deficits and get more capital flows than developing economies. In other words, the capital flows from developing economies to developed economies and not the other way round. There are a number of theories on why the capital does not flow from developed to developing (limited financial development, risk of defaulting etc) but that is a topic of separate research. Another point is that this trend of capital flow from developing to developed was first identified in 1985 by Robert Lucas and since then some changes have taken place. Some developing countries are instead inviting huge capital flows. Hence, in this research, the discussion will be limited to the global imbalances. Figure 1: Current account balances (in USD million)
800 600 400 200 0 -200 -400 -600 -800 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008

Source: IMF, IDBI Gilts Ltd.


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And causality probably runs to some extent in the other direction as well. As a result.0 100. But after Euro adoption. There are some reforms needed as factors of production (labour. USD remained the only available option for the investors. Developing Asia and Middle East contribute almost 86% of current account balances in 2006. The investors should have moved their surpluses away from US given the above problems. but has not taken off. The consumption of US Households has been increasing over the years and is almost equal to their disposal incomes (Figure 2). Middle-east etc continues to be parked in US and not in Euro. Despite the shift to Euro. Theoretically. ! The dollar did not depreciate as there is huge demand for US assets (mainly treasuries) from developing countries. The percentage holding in US Dollar denomnated assets has declined from 70% in 1995 to about 60% in 2007 and the contribution of Euro has increased from 19% in 2000 to 29% in 2007. wealth effects etc) but dollar did not depreciate due to other global factors (explained below).0 96. US dollar continues to be the preferred currency and because of the demand the USD did not depreciate.Economic Research – Can subprime crisis help unwind the global imbalances? Reason for global imbalances ! The source of these global imbalances has been high consumption or low savings of US households. IDBI Gilts Ltd.0 82.0 90.0 92. current account surpluses are being invested mostly in US assets (Figure 3). We noted a number of channels by which higher house prices can lead to higher debt. Euro Region is as big as US and has some developed economies. Japanese problems are well known but even Europe continued to struggle (now.0 84. The developing countries have been running current account surpluses and the surpluses are invested in US treasuries.easy financing of extra investments.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Bureau of Economic Analysis. Middle East Asian countries have surpluses on account of rising oil prices. As a result the savings rate of US households has been almost zero resulting in huge current account deficits. This implies demand for dollars continues and the dollar does not depreciate. India.Europe and Japan.0 98. especially in light of financial innovation that has reduced the cost and increased the availability of housing finance. either the US should save more or the dollar should depreciate to correct the huge current account deficit. There were only two economies that could compare to the size of the US economy. US assets are still considered to be safer. There is wide research looking at possible reasons for the rising US household debt and the broad finding is that it is because of financial innovation and housing prices.0 88.0 94. thereby helping them smooth consumption of all goods and services. The saving increase only over a period of time (there are a number of factors like. Most surplus money from China. capital) are still not fully mobile in Euroregion. A recent Fed paper noted (2007): The most important factors behind the rise in debt and the associated decline in saving out of current income have probably been the combination of increasing house prices and financial innovation. it is showing resurgence post Germans showing strong growth). Hence. Figure 2: Consumption as a % of Disposable Income 102. Where Developing Asia runs current account surplus on account of its export driven growth. Another source of demand for dollar is South East Asian Nations like Korea. ! 2 . Within developing countries.0 86. Innovation has opened up greater opportunities for households to enter the housing market and for homeowners to liquefy their housing wealth. Indonesia etc which are maintaining huge forex reserves both to prevent their currencies from appreciating and have adequate reserves for any crisis ( a learning from the South East Asian crisis in 1997).

and gradually increase exchange rate flexibility. In product markets. ! 3 . The word became poular after the Bernanke speech (2005) where he linked the global imbalances with the global saving glut hypothesis." IMF keeps coming out with reports covering the developments so far. 2006. (2) The figure for 2007 is upto 3rd quarter Source: IMF. the Euro Area. or they represent a large share of global output. to reform the trade system.Economic Research – Can subprime crisis help unwind the global imbalances? Figure 3: Forex reserves holdings of Developing Countries in U. but the size of the imbalance also became bigger with time leading to concerns from economists and policymakers.S. IMF initiated a program called 'Multilateral Consultation on Global Imbalances'. "Their cooperative action can play a major role in the orderly unwinding of these imbalances and in sustaining global growth as savings. the authorities are pressing ahead with structural reforms across a broad front to strengthen competition and productivity. to address these global imbalances is a challenge. The press release says: The first multilateral consultation will focus in a comprehensive and collective way on the issue of global imbalances and involve several systemically important members and groups of members-China. In labor markets. Japan. only allocated reserves has been taken. However. Saudi Arabia and the United States-all of which have agreed to participate in this first consultation. Since then there has been numerous research looking at various facets of the imbalance. One coulbdn't point to a single country and start working on the same. the main planks the implementation of the Services Directive and the development of more competitive network industries in individual countries. accelerate financial sector reform. Bernanke recently revisted the subject (in 2007) and suggests that imbalnanes have unwinded slightly. IDBI Gilts Ltd Addressing global imbalances Not only global imbalances continued to persist. adding. dollar (in %) 75 70 65 60 55 50 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 Note: (1) IMF classifies the forex exposure in allocated categories and unallocated exposures. steps are being taken to foster greater labor utilization and productivity and the mobility of labor. In this it brought together the top policymakers of the countries/regions involved in the imbalances. consumption and investment patterns adjust." Mr. Financial market reforms include measures to facilitate mergers and acquisitions. It needed a global effort. and implementing a range of initiatives aimed at harmonizing and integrating financial markets. The main developments are: ! China : indicated that the reduction of external imbalances had been elevated to a major national objective in 2007. In this connection. IMF had an alternate view suggesting that it was not as much a problem of high savings but that of lower investment levels worldwide. It began in June 5. Euro area. they are pursuing measures to boost domestic demand-particularly rural consumption. "These economies are either ones with large current account surpluses or deficits. de Rato noted. In this research. The last such report came out in June 2007.

including expanding oil sector capacity. The crisis has led to depreciation of the USD. Meanwhile. the US policymakers pressurised the Chinese to appreciate its currency and asked Developing Asia not to intervene in forex markets and allow their currencies to be market determined. As housing prices have started falling. It has depreciated against most currencies till date. This included additional steps to enhance labor mobility. accompanied by measures to reform the budget rocess and slow the rate of growth in health care costs. So if we are to correct the problem within the US economy. Then came the subprime The subprime crisis if it creates the damage it is expected to.Economic Research – Can subprime crisis help unwind the global imbalances? ! Japan: the authorities plan to advance structural reform to strengthen competition and enhance flexibility. it can happen only if savings increase and USD depreciates. Many of the Developing Asian countries are dependent on US imports and if it starts declining then the trade surpluses generated over the years would also decline. could help unwind the imbalances. it could just bring the much needed good luck. As it has been pointed above the US households have very low saving rates and this is leading to high currenct account deficits and related problems. reform and privatize some government-owned financial institutions. United States: authorities plan to raise national saving through further fiscal consolidation over the medium term. and further advance fiscal consolidation to sustain domestic confidence. The rising housing prices have in turn led to higher wealth and higher consumption. including the achievement of a balanced unified federal budget by FY2012. and measures to support private savings. This would also lower the magnitude of imbalances. including through reform of the tax treatment of mergers and acquisitions. The savings have been low because of rising housing prices and financial innovation which has allowed households convert their houses like financial assets which are then traded in the markets. Not much happenned though on both the front and imbalances continued.S. strengthen capital market competitiveness. and ensure the United States remains an attractive environment for foreign investment. as well as to enhance energy efficiency. saving rate and a policy of fiscal stimulus in other countries. facilitate inward foreign direct investment. The reason was to make US exports more competive and imports more expensive to consume. The further weakening would also depend on how other developed economies fare in the crisis. Sub-prime crisis brings good luck? The sub-prime crisis is a result of a number of weak policies but as far as unwinding global imbalances is concerned. ! The subprime crisis has led to decline of housing prices (Figure 4). broaden the application of deregulation already in force. imbalances would be a substantial fall of the dollar followed by a significant rise in the U. As it has been explained above the main reason for high consumption levels is that households took on increasing debt on account of rising prices. ! ! 4 . This would lead to reducing of the current account deficit and also lower the consumption levels leading to unwinding of the global imbalances. Achieving this will require both good policies and good luck. their execution would significantly reduce the current account surplus in the coming years. Saudi Arabia: the authorities intend to continue to increase spending on social and infrastructural investments in key areas. this would lead to lower consumption and encourage higher savings. Martin Feldstein commented in his paper (2007): The best hope for a smooth adjustment of both the global and U. ! ! The IMF program is a good step but will take a long time to fructify. As these investment programs have a high import content.S.

from time to time may solicit from. have positions in. Investors must make their own investment decision based on their own investment objectives. It is difficult at anytime to justify recession but the conditions have been such globally that it might just be welcome. Janmabhoomi Marg. IDBI Gilts. the economies could either have responded by coordinating and correcting the same vigrously. There have been excesses for many years and a sharp reversal was the only way it could be corrected. The securities discussed in this report may not be suitable for all investors. excessive debt and a huge current-account deficit) in place. The weakest link in the chain was the high consumption levels in US and should also create the maximum impact in correction of the imbalances. Fax: (91-22) 66177999 Disclaimer This report has been prepared by IDBI Gilts Limited (IDBI Gilts) and is meant for the recipient for use as intended and not for circulation. its directors or employees may from time to time. Otherwise. Delaying the correction of past excesses by pumping in more money and encouraging more borrowing is likely to make the eventual correction more painful. Some economists believe that recessions are a necessary feature of economic growth. (This was a point IDBI Gilts made in its previous research report . the only way it could have corrected was a sharp adjustment in individual economies. The Economist (dated 25 August 2007) had said something similar at the onset of the sub-prime crisis: The economic and social costs of recession are painful: unemployment. leaving the economy in a healthier state.Economic Research – Can subprime crisis help unwind the global imbalances? Figure 4: Case Shiller Composite Index 210 205 200 195 190 185 Sep-06 Mar-06 Mar-07 Nov-06 May-06 May-07 Sep-07 Jul-06 Jan-06 Jan-07 Jul-07 Source: S&P. Final thoughts US recession could actually be beneficial in many ways. These cannot be dismissed lightly. However. and buy and sell securities referred to herein. It may be a choice between a mild recession now and a nastier one later. the economists do not seem to be sharing the same belief and seem to be concentrated on the fallout of the subprime crisis. its directors and employees will not in any way be responsible for the contents of this report. The information contained herein is from the public domain or sources believed to be reliable. Joseph Schumpeter argued that recessions are a process of creative destruction in which inefficient firms are weeded out. were suggesting different ideas when it was expected to decline. This is not an offer to sell or a solicitation to buy any securities. or options on. 2007). The policy dilemma facing the Fed may not be a choice of recession or no recession. IDBI Gilts. lower wages and profits. This report should not be forwarded or copied or made available to others. A recession now would reduce America's trade gap as consumers would at last be forced to trim their spending. While reasonable care has been taken to ensure that information given is at the time believed to be fair and correct and opinions based thereupon are reasonable. Janmabhoomi Bhavan. during the normal course of business. Fort. leaving America's imbalances (inadequate saving. due to the very nature of research it cannot be warranted or represented that it is accurate or complete and it should not be relied upon as such. But there are also some purported benefits. and bankruptcy. As there is no surety on the magnitude of the subprime crisis. IDBI Gilts. The same economists who advocated that US consumption needed to decrease if the imbalnces have to be limited. As it was global in nature. one cannot say whether it would help unwind global imbalances or would just be a starting point. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and simply replaced one bubble with another. IDBI Gilts Ltd. for any company mentioned in this report. there is high possibility of more to come. IDBI Gilts Limited (A wholly owned subsidiary of IDBI Ltd. 5 . If it just turns out to be a starting point.) 1st Floor. or perform investment banking or other services. goals and financial position and based on their own analysis.Is 50 bps rate cut justified? dated September 25. Phone: (91-22) 6617 7900. Another "benefit" of a recession is that it purges the excesses of the previous boom. Mumbai – 400 001.

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