“History suggests that a deficit of seven-plus percent [of GDP] and rising rarely end happy,” said President Summers in a speech last Wednesday at the Burden Auditorium. The former Treasury Secretary, in possibly his last address to the Harvard Business School as Harvard President, warned the large RC audience of the dangers of a ballooning US current account deficit being financed largely by short term debts from emerging markets.
As Summers pointed out, if the US current account were to be scrutinized like our personal or household accounts, we would be “very alarmed.” The current account has grown steadily over the years and now stands at around 6% of GDP. In 2005, $805 billion worth of capital flowed into the US to finance the current account deficit, 41% of which were from oil exporting countries and more than 25% of which from China and emerging Asia. Historically, the British and the Romans had exported capital out to their colonies and to the rest of the world at the height of their empires. “We have the strange situation now that the richest, most powerful country is borrowing from poorer or emerging areas,” said Summers.
However, the other side of the borrowing equation suggests that capital is readily available to the US at very low rates. Not only are the capital flows from emerging markets, they are also primarily from government reserves, rather than investment flows from the private sector. Reserves from developing countries have reach $2 trillion, largely in excess of the minimum amount required for each country to cover one year’s worth of short term debt. Moreover, reserves in developing countries are growing at a rate of $500-600 billion a year. Real interest rates are low; after inflation is taken into account, short term bills have real returns of only 1.5-2% in dollar terms. Measured in emerging markets’ currencies, which are likely to appreciate over the next 5 years, returns are negative.
Summers stressed that financing the deficit may be cheap at the moment but it is not sustainable. Most of the deficit is not generating future growth through investment, but is instead financing consumption. Moreover, a larger proportion of investments at the moment is being made in the non-tradable sector (e.g. services), not in the tradable sector which would be able to offer goods for export in the future to redress the balance.
This situation will not last long. “Some adjustment will be necessary soon,” said Summers, pointing out that the US dollar will fall rapidly and American asset prices will collapse the adjustment occurs. He suggested that the US Federal Reserve may soon find itself facing the same hard choices as the Asian central banks during the Asian Financial Crisis in 1998 – raise interest rates to support the currency or reduce interest rates in order to relieve the banking sector and boost the economy.
Any attempt to correct the imbalance, however, cannot be done in isolation in the U.S. As Summers noted, one cannot assume that the situation will be resolved if Americans were to increase their savings rate and replace some of their consumption with exports. Since the US is driving more than half of the demand in the world economy, any attempt to move from import-led economic growth to export-led growth will lead to huge adjustments in the current accounts of the rest of the world. If demand generation is not picked up by other countries, world economic growth will slow. “The trick is to achieve a coordinated response,” Summers noted. On the flip side, even if the current account situation improves, there remains the question of what developing countries will do with their reserves in an environment of low, even negative returns. Careful reflection on how these resources would be best deployed will be needed.
Summers’ call for a coordinated response echoed the IMF, which has been advocating what Raghuram Rajan, chief economist at the IMF, describes as a “mutually agreed, credible, multilateral framework for policy action, with specifics on measures and timing.” However, the difficulties of coming to an agreement has led to inaction to date, despite the IMF’s warnings that the risk of a disorderly decline in the dollar has increased significantly and that a global slowdown is likely if the US and Chinese economies were to falter simultaneously. On the other hand, the former Chairman of the Federal Reserve, Alan Greenspan, told the FT Asian Financial Centers summit last month that such coordination is “unlikely” and that a more plausible path is for individual countries to allow market forces to operate more effectively. Whatever the course of action, what is clear is that the current account imbalances must be addressed quickly if the world economy is to be sustained in its present growth path.