The New Structure of Global Balances
An
unusual and striking feature of the current global balance of payments
situation is the huge deficit on the current account of the world’s
dominant country, the United States, which is partly being financed
with surpluses in the current and capital account of developing countries,
especially those in developing Asia. At the end of the second quarter
of 2004, the annual current account deficit in the US balance of payments
stood at $572 billion and was forecast to touch 5.5 per cent of GDP
in 2004. At around the same time, 9 developing countries in Asia and
Latin America (Brazil, China, Hong Kong, India, Indonesia, Malaysia,
Singapore, South Korea, Taiwan, and Venezuela) were recording an annual
surplus of around $190 billion on their current account.
To boot, many of these developing countries were recipients of large
capital inflows-in the form of foreign direct investment, portfolio
capital and debt-resulting in surpluses on the capital account. Together
these current and capital account surpluses were adding to their reserves,
which in turn were being invested in dollar denominated financial assets,
thereby financing in part the US deficit.
Weekly data from the Federal Reserve relating to November 3, 2004 showed
the Fed's holdings of assets for official institutions - which is a
proxy for foreign central bank holdings - rose over the previous year
by $253.6 billion to $1,053 billion. This compares with a rise of $217
billion during the whole of 2003. Needless to say, not all of these
investments are from developing countries, since Japan is a major investor.
The Japanese government spent a record $180 billion in 2003 on intervention
in foreign exchange markets and much of that money found its way into
the US Treasury market. During that period, Japan's foreign exchange
reserves rose by $203.8 billion to $673.5 billion. In the first two
months of this year, those reserves rose a further 15 per cent to $776.9
billion. While developing countries may not be playing a similar role,
their contribution is still important.
As Chart 1 shows, the current account deficit in the US has widened
continuously since the mid-1990s, resulting in an overall deficit for
all advanced economies, despite the fact that every one of them has
shown surpluses in almost all those years. On the other hand, during
this period developing countries as a group have seen a transformation
of their current account deficits into surpluses (Chart 2). While this
was true initially of a set of countries in Asia, they have since been
joined by countries in West Asia, the Commonwealth of Independent States
(included by the IMF in the developing countries and emerging markets
group) and Latin America, though not Africa and Central and Eastern
Europe. However, developing and emerging market countries outside Developing
Asia have also been recording a surplus as a group.
This implies that three decades of globalisation have fundamentally
transformed the international balance of payments situation. Prior to
the oil shocks, which were important triggers for the major changes
in the quantum and nature of international capital flows, the international
payments scenario reflected differences in the global economic strength
of individual nations. The scenario was one where the developed countries
recorded large surpluses, the oil-exporting developing countries much
smaller surpluses and the oil-importing developing countries were burdened
with significant deficits. The process of restoring global balance involved
adjusting growth in the oil-importing developing countries so as to
tailor their deficits to correspond to the extent to which surpluses
from the developed countries could be recycled to finance those deficits.
Though for a short period after the oil shocks of the 1970s this situation
changed with surpluses in developed countries falling, those earned
by the oil exporters rising sharply and deficits in the oil-importing
developing countries exploding, the picture returned to its pre-oil
shock form by the 1980s. Even when oil exporters were earning large
surpluses, the fact that these surpluses were being deposited within
the banking system in the developed world made the process of recycling
surpluses one of transfers from the developed to the oil-importing developing
countries. The real change was that private rather than official flows
through the bilateral and multilateral development network came to dominate
capital flows.
Associated with this shift was a transformation of capitalism in the
developed countries which witnessed the rise to dominance of finance
capital. To start with, oil surpluses deposited with the international
banking system resulted in a massive increase in credit provision, both
within the developed countries and in the so-called emerging markets.
Second, the breakdown of the system of fixed exchange rates triggered
by the US decision to delink the dollar from gold, resulted in a sharp
increase in foreign exchange trading. Third, growing exposure of financial
agents in domestic and international debt markets and in foreign exchange
markets resulted in the burgeoning of derivatives that allowed financial
institutions to hedge their bets by transferring credit risk. And, finally,
the liberalisation of financial markets in developing countries aimed
at exploiting the benefits of a global financial system awash with liquidity
provided an opportunity for banks, pension funds and other financial
firms to increase their investments in developing countries in search
of lucrative returns.
The long term effects of these developments are there to see. Available
figures point to galloping growth in the global operations of financial
firms. In the early 1980s, the volume of transactions of bonds and securities
between domestic and foreign residents accounted for about 10 per cent
of GDP in the US, Germany and Japan. By 1993, the figure had risen to
135 per cent for the US, 170 per cent for Germany and 80 per cent for
Japan. Much of these transactions were of bonds of relatively short
maturities.
Since then, not only have these transactions increased in volume, but
a range of less traditional transactions have come to play an even more
important role. Traditional bank claims, though important, are by no
means dominant. Banks reporting to the Bank of International Settlements
(BIS) recorded foreign claims on residents of all countries at $15.7
trillion at the end of 2003. This compares with the annual global GDP
of $36400 trillion in that year.
Non-bank transactions have been far more important. In 1992, the daily
volume of foreign exchange transactions in international financial markets
stood at $820 billion, compared to the annual world merchandise exports
of $3.8 trillion or a daily value of world merchandise trade of $10.3
billion. According to the recently released Triennial Central Bank Survey
of Foreign Exchange and Derivatives Market Activity, in April 2004,
the average daily turnover (adjusted for double-counting) in foreign
exchange markets stood at $1.9 trillion. With the average GDP generated
globally in a day standing at close to $100 trillion in 2003, this appears
to be a small 2 per cent relative to real economic activity across the
globe. But the sum involved is huge relative the daily value of world
trade. In 2003, the value of world merchandise exports touched $7.3
trillion, while that of commercial services trade rose to $1.8 trillion.
Thus, the daily volume of transactions in foreign exchange markets exceeded
the annual value of trade in commercial services and was in excess of
one quarter of the annual merchandise trade.
The trade in derivatives is also large and significant. The Triennial
Survey indicates that the average daily volume of exchange traded derivatives
amounted to $4.5 trillion in 2004. In the OTC derivatives market, average
daily turnover amounted to $1.2 trillion at current exchange rates.
The OTC market section consists of ''non-traditional'' foreign exchange
derivatives - such as cross-currency swaps and options - and all interest
rate derivatives contracts. Thus total derivatives trading stood at
$5.7 trillion a day, which together with the $1.9 million daily turnover
in foreign exchange markets adds up to $7.6 trillion. This exceeds the
annual value of global merchandise exports in 2003.
One consequence of these developments was that the flow of capital to
developing countries, particularly the ''emerging markets'' among them
had nothing to do with their financing requirements. Capital in the
form of debt and equity investments began to flow into these countries,
especially those that were quick to liberalize rules relating to cross-border
capital flows and regulations governing the conversion of domestic into
foreign currency. The point to note is that these inflows did not spur
substantial productive investment in these countries. Even foreign direct
investment, defined as investment in firms where the foreign investor
holds 10 per cent or more of equity, had ''portfolio'' characteristics,
and often took the form of acquisitions rather than greenfield investment.
What is important from the point of view of global balances is that
the inflow of such capital imposes a deflationary environment on developing
countries, because one requirement for keeping financial investors happy
is to substantially reduce the deficit of the government or its expenditures
financed with borrowing. Financial interests are against deficit-financed
spending by the State for a number of reasons. To start with, deficit
financing is seen to increase the liquidity overhang in the system,
and therefore as being potentially inflationary. Inflation is anathema
to finance since it erodes the real value of financial assets. Second,
since government spending is ''autonomous'' in character, the use of
debt to finance such autonomous spending is seen as introducing into
financial markets an arbitrary player not driven by the profit motive,
whose activities can render interest rate differentials that determine
financial profits more unpredictable. Finally, if deficit spending leads
to a substantial build-up of the state’s debt and interest burden, it
may intervene in financial markets to lower interest rates with implications
for financial returns. Financial interests wanting to guard against
that possibility tend to oppose deficit spending. Given the consequent
dislike of expansionary fiscal policy on the part of financial investors,
countries seeking to attract financial flows or satisfy existing financial
investors are forced to adopt a deflationary fiscal stance, which limits
their policy option.
Part of the reason why developing countries record a surplus on their
current account is the deflationary fiscal stance adopted by their governments.
Growth is curtailed through deflation so that, even with a higher import-to-GDP
ratio resulting from trade liberalisation, imports are kept at levels
that imply a trade surplus. Consider the flows that deliver current
account surpluses for developing countries? As Table 1 shows, two factors
account for these surpluses: first, the transformation of the trade
deficit (goods and services) in these countries into surpluses, and
a substantial inflow of current transfers, mainly in the form of remittances.
So, unless exports of goods and services and/or remittances are large
and growing, deflation must be the factor influencing the current account.
Table
1: The Current Account of Developing and Emerging Market Countries ($ billion) |
||||||||
1996 |
1997 |
1998 |
1999 |
2000 |
2001 |
2002 |
2003 |
|
Current
account balance |
-86.1 |
-85.3 |
-116.3 |
-18.9 |
86.3 |
39.5 |
84.21 |
148.9 |
Balance
on goods and services |
-46.6 |
-45.6 |
-66.1 |
42.2 |
147.9 |
93.5 |
128.6 |
183.4 |
Income,
net |
-83.7 |
-91.8 |
-99.5 |
-114.3 |
-188.3 |
-116.9 |
-124.5 |
-137.3 |
Current
transfers, net |
44.2 |
52.1 |
49.2 |
53.2 |
56.7 |
63 |
80 |
102.7 |
In
sum, while the inflow of remittances is reflective of one aspect of
the process of globalisation that has benefited developing countries,
the rise of trade surpluses reflect the deflation imposed by financial
flows and the financial crises they engineer in some countries. As a
result, developing countries as a group did not require capital inflows
to finance their balance of payments. But such inflows did occur, particularly
in the form of private foreign investment. Such capital inflows then
either went out as other net investment or were accumulated as reserves
that were invested in large measure in US Treasury bills. That is, private
capital flowed into developing countries to earn lucrative returns,
and this capital then flowed out as investment in low interest Treasury
bills in order to finance the US balance of trade deficit.
What is more, if a country is successful in attracting financial flows,
the consequent tendency for its currency to appreciate forces the central
bank to intervene in currency markets to purchase foreign currency and
prevent excessive appreciation. The consequent build-up of foreign currency
assets, while initially sterilized through sale of domestic assets,
especially government securities, soon reduces the monetary policy flexibility
of the central bank. Governments in Asia, especially India, faced with
these conditions are increasingly resorting to trade and capital account
liberalization to expend foreign currency and reduce the compulsion
on the central bank to keep building foreign reserves. That is, if financial
liberalisation is successful, in the first instance, in attracting capital
flows, it inevitably triggers further liberalization, including of capital
outflows, leading to an increase in financial fragility.
Thus, financial liberalisation that successfully attracts capital flows
increases vulnerability and limits the policy space of the government.
Unfortunately, the dominance of finance globally has meant that such
debilitating flows occur even when individual developing countries or
developing countries as a group have no need for such flows to finance
their balance of payments or augment their savings. The real benefit
of such flows is derived by the US government, which, being the home
of the reserve currency can resort to large scale deficit financing
which it opposes in developing countries. The resulting balance of trade
and current account deficits are not a problem because they are financed
with capital flows from the rest of the world including ''emerging market''
developing countries. The problem now is that the willingness of private
investors and governments to hold more dollar denominated assets is
waning. If that continues a crisis at the metropolitan centre of global
capitalism is a possibility.