April 14, 2011

The imbalances are alive

“Too often, the policy response to a sharp adjustment to an unsustainable position starts and ends with the provision of liquidity. Rarely, however, is the problem a temporary shortage of liquidity. As we have seen since 2007, and on many occasions before that, most p layers – whether financial institutions or countries – would like others to believe that greater provision of liquidity is the answer. Almost always, the provision of liquidity works only when it is the bridge to a more fundamental solution…. There is much to do. None of the underlying causes of the current crisis have been removed. The problem of “too important to fail” banks is still with us. Today, the most obvious problem at the global level is that the imbalances are growing again”

So said Mervyn King, the governor of the Bank of England in California in March. It does not take much guessing to know that the target of his remarks was the US Federal Reserve. His message, however, did not hit the target. Few days after he spoke, the Federal Reserve Open Market Committee met to decide on monetary policy setting in the United States. It vowed to maintain exceptionally low rates for an extended period as they had done ever since they reduced the federal funds rate to between 0 and 0.25 percent late in 2008. It is more than two years since rates were dropped to such low levels. It remains there and might remain there even into 2012.

Raghuram Rajan, professor of finance at the University of Chicago, warned of the global risks building in 2005. He was ignored at best and ridiculed at worst. He is now again warning of the dangers of excessive risk-taking induced by the ultra-low interest rate policy. The Federal Reserve though, is not listening. There were no dissenters at the Federal Reserve monetary policy committee Meeting. Groupthink thrives.

The president of the Federal Reserve Bank of New York William Dudley (formerly and economist with Goldman Sachs) recently told an audience in Queens, New York that they should look at broader prices rather than at food and energy alone. He pointed to how the iPad2 was being offered at the same price as the first-generation iPad despite improved computing power. Someone in the audience muttered that people do not eat iPads. No wonder the Federal Reserve is pointing to the subdued rate of core inflation (inflation rate that excludes inflation in energy and food prices) in official data. This is what they did in 2005-07 and imbalances built up in the United States and in the world economy. The world paid a price in 2008 and it risks paying a bigger price in 2011-12.

Slow recovery, widening deficits
The United States reported a trade deficit of $46 billion in January. It was worse than the deficit of just over $ 40 billion reported in December. It was also much higher than what economists had anticipated. The balance in goods was a deficit of $59 billion while the balance in services was a surplus of $13 billion. Industrial supplies constitute an important element of US imports, amounting to nearly one-third of the total goods imports of $180 billion. Of the nearly $60 billion of industrial supplies imports, about $34 billion were due to crude oil and petroleum products. But, this item constituted $31 billion of imports in December.

In other words, the jump in the trade deficit in January cannot be attributed to the jump in the global price of crude oil yet. If the US economy remains on the recovery mode and if global crude oil prices remain elevated, then the path for future US trade deficits is clear. They would continue to widen. At a monthly deficit of $46 billion, the annual deficit is about $550 billion and constitutes 3.7 percent of US GDP. That is on the borderline of a sustainable trade deficit. Add the deficit from invisibles and the United States will have a current account deficit that would exceed 4 percent of GDP. Economic recovery would only further enlarge the deficit. The problem of funding the US current account deficit that was a big issue before 2008 would be back on the table.

It would be one more confirmation that neither the crisis nor the subsequent recovery measures taken by governments have done anything to address the underlying imbalances. There are, in fact, two imbalances. One is the excess spending by the United States and excess saving in China. The other is the imbalance between growth ambitions and the ceiling imposed by the current global resource endowments. That is what triggered the spike in the price of crude oil in 2007-08 and that is what is at play again this time around, with prices of many commodities rising alarmingly. Clearly, loose monetary policy from the United States is playing a role in stoking speculative demand for commodities. But, strong demand arising out of global recovery and rising incomes from the developing world and reduced supply caused by both one-off and structural factors are also underpinning prices.

Let us focus on first: one of excess spending in the US. After all, the import of consumer goods has picked up from $36.5 billion in January 2010 to $41.6 billion in January 2011. The US household savings rate improvement has stalled although it picked up a bit in January. Furthermore, there are record deficits of the government to finance. Hence, the United States is far from doing what is needed to rebalance its economy.

So far, the United States has had no problems funding its trade deficit since there is a certain natural demand for the US dollar. Foreign purchase of US securities has continued to take place.

Lending to America
The US treasury department updated the figures on the purchase of US securities by foreigners. The amount of US treasury securities held by China was revised higher to $1.11 trillion in June 2010 from the originally estimated figure of $844 billion. How did this happen?

When treasuries are bought by foreigners, they are initially counted against the place of purchase. If the order came from Britain, it is counted as a purchase by Britain. Subsequently, when the purchases are traced to the domicile of the underlying purchaser, then they are re-classified. The choice of Britain as an example is deliberate, because, as China’s holding of US treasuries was revised higher, British holdings were drastically revised lower. This is not surprising since many of the sovereign wealth funds and developing countries’ central banks buy through accounts held in Britain.

As of end-December 2010, China holds $1.16 trillion of US treasury securities. Foreigners, in total, have lent $4.44 trillion to the United States. The latter has outstanding marketable treasury debt securities of around $8.86 trillion. So, foreigners, as of the end of last year, held nearly half of all the marketable US public debt. China’s share constituted 25 percent of the foreign lending to the US government.

More than the upward revision to China’s holding of US treasuries, what is interesting to note is the trend in China’s holding of US treasury securities: Beijing has been progressively reducing its purchase of US treasuries until recently. In the last quarter of 2010, China’s purchases have picked up.

It is difficult to know what to make out of it. At one level, the United States is finding buyers for its debt. At another level, it means that China is still managing its currency down rather than gradually let market forces determine its value. At the global level it is not good news, since it was China’s excess saving that partially funded the egregious leverage of the US financial system. That ended in tears. Now, it appears to have shifted from agency securities to treasury securities. How this one would end is anyone’s guess. It is hard to imagine, though, that this is good news for global economic and financial stability.

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