July 13, 2009 Augusto de la Torre, Sergio Schmukler, and Luis Servén
Forces unleashed by the 2008-2009 financial crisis have kept U.S. assets attractive and the dollar strong, contrary to what many observers expected. Over the long run real sector and financial sector forces are likely to impose a correction, perhaps involving a depreciation of the dollar and a major reallocation of international portfolios.
The current global financial crisis unfolded in an unexpected way. Prior to the crisis, many had argued that the cross-country current account balances were unsustainable and would be eliminated through a drop in the demand for U.S. assets, implying a sharp devaluation of the U.S. dollar and an increase in U.S. interest rates.
To the contrary, the crisis has brought an appreciation of the dollar and record-high U.S. government bond prices. Will the recovery from the crisis entail a return to the old order?
The new global equilibrium will be shaped a variety of real and financial forces
The world economy exhibited large imbalances over the last 10 years, as the United States financed its mounting current account deficits with borrowing from abroad (Figure 1).
Booming capital inflows, rapidly growing exports, and favorable terms of trade for commodity exporters allowed many developing countries to build up large foreign asset positions, in the form of reserves (largely U.S. Treasury bills) and investment in private assets.
The accumulation of foreign assets was driven by several factors, including high savings rates in Asian countries, the desire of emerging markets to self-insure against crises, and a policy to forestall further appreciation of developing country currencies and encourage export-based growth.
The resulting equilibrium looked fragile to many since it hinged on foreign lenders willing to buy virtually unlimited amounts of U.S. assets to continue financing U.S. current account deficits. To others, the equilibrium looked more durable, as it enabled high-saving but financially underdeveloped countries to use the services of the financial markets of rich countries.
Most observers expected an unwinding of global imbalances sooner or later, with a shift from U.S. assets to other international assets, with the euro bound to gain.
The crisis affected the magnitude and the financing of global imbalances
When the subprime crisis erupted in the United States, world gross capital flows collapsed. Residents of most countries stopped sending capital abroad, and turned to domestic assets. Moreover, the collapse in global trade and commodity prices reduced the financing available from countries with large trade surpluses.
Also, the U.S. current account deficit shrank significantly, from 6.61% of GDP in the fourth quarter of 2005 to 2.88% of GDP in first quarter of 2009. On net, however, the United States was still able to finance its deficit (albeit a smaller one), partly by U.S. residents bringing home their foreign securities (Figure 2).
The crisis also had unexpected effects on the global economy
The fact that all major economies were hit (along with the United States) undermined the expected shift out of U.S. assets. Most notably, the propagation of the crisis to Europe (initially perceived to be less vulnerable to subprime risk) prevented a substitution of euros for dollars.
In fact, the U.S. dollar appreciated relative to reserve and non-reserve currencies around the world. Furthermore, the increase in risk aversion encouraged a portfolio shift to U.S. Treasury bills by both U.S. and foreign investors at the expense of equity, corporate bonds, emerging market bonds, money market funds, bank deposits, and any other asset that entailed credit risk.
Ultimately, the U.S. dollar became the reserve currency of last resort and the U.S. government became both the borrower and creditor of last resort. Even though the United States was the source of the crisis, it was still perceived as a safe haven by international investors.
Some of these trends are likely to be temporary. As risk aversion diminishes (with companies returning to profit and credit worthiness), investors are likely to increase their appetite for risky assets, in the United States and elsewhere, and the collapse in capital flows will abate.
This will push asset prices up and appreciate exchange rates (against the U.S. dollar), and/or imply higher U.S. interest rates. In fact, stock prices and currencies in some emerging economies have rebounded (though from a very low level) since the beginning of the 2009.
The post-crisis global equilibrium and the future of global imbalances will also be shaped by a variety of real and financial forces
Global imbalances may not fully disappear as a result of this crisis alone, at least in the short run. Some forces may keep U.S. assets attractive and the dollar strong, decreasing the need for a reduction of imbalances.
At the global level, the current crisis has highlighted the effectiveness of self-insurance, as those countries that had amassed large stocks of liquid foreign assets have been able to weather the storm better than the rest. This may encourage countries to strengthen their external buffers, further increasing their holdings of safe and liquid world assets.
Also, as international trade resumes and commodity prices stay above their recent lows, emerging economies may return to large trade surpluses and foreign asset accumulation. Those asset holdings may be channeled again to the United States, provided adequate U.S. government actions (including a timely unwinding of the recent expansion of the Federal Reserve’s balance sheet) succeed in preventing inflation or depreciation from unduly undermining asset values.
In addition, as the U.S. economy recovers, the increase in private consumption, combined with the large fiscal expansion, may halt the decline in the U.S. current account deficit. Lastly, the resilience of the U.S. dollar and Treasury bills during the crisis, and the Federal Reserve’s unique capacity to act as the lender of last resort and its undisputed record of having been a world leader in managing the crisis, might attract more demand from investors that would have otherwise gone elsewhere, and might help in the U.S. recovery.
But other adjustments could push the global equilibrium in the opposite direction. The incipient availability of enhanced country insurance mechanisms (such as the International Monetary Fund’s contingent credit facilities) may reduce the appeal of foreign asset hoarding for self-insurance purposes in emerging markets.
Stricter financial regulation in advanced economies is likely to undermine the franchise value of financial institutions, adding to the adverse wealth effect on aggregate demand of weak asset prices, thus putting downward pressure on current account deficits, especially in the United States. In turn, policies (such as enhanced safety nets and other expansionary fiscal actions) that reduce saving rates in Asian countries would decrease their external surpluses. A major shift by international investors, and surplus countries in particular, toward currencies other than the dollar could also bring global imbalances to an end.
Lastly, the future equilibrium outcome will be shaped by the effectiveness, and the unwinding, of U.S. monetary and fiscal stimulus, which will affect the value of the net debt of the U.S. government. If asset prices do not continue to firm up and the recovery lags, or if expansionary policies are not reversed in a timely fashion, net U.S. debt will be correspondingly higher, and will likely result in a larger depreciation of the U.S. dollar.
To the extent that the United States is expected to outperform other major industrial countries in the medium term, it might continue receiving foreign capital and the previous pattern of global imbalances might be gradually restored, at least in part.
In that case, and in a similar fashion as pre-crisis capital inflows to the United States led to an exuberant expansion of the real estate sector, an appreciation in other (old or new) U.S. risky assets, may well develop.
However, the post-crisis real and financial adjustments suggest that the previous distribution of large imbalances will be difficult to restore and even more difficult to sustain over the long run. Thus, it would be unwise to dismiss the prospects of an eventual major depreciation of the U.S. dollar against different currencies around the world and of a correspondingly much higher diversification of emerging market holdings into non-U.S. assets.
Augusto de la Torre is the chief economist for the World Bank for the Latin America and Caribbean Region.
Luis Servén is research manager for the Macroeconomics and Growth research team in the Development Research Group at the World Bank. His research interests include open economy macroeconomics, fiscal policy and growth, exchange rate regimes, international portfolio diversification, saving and investment determinants, and microeconomic regulation and growth.
Sergio Schmukler is a lead economist in the Development Research Group of the World Bank (Macroeconomic and Growth team). His research interests include international finance and international financial markets and institutions.
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Figure 1 presents the U.S. current account balance as a percentage of GDP compared to the real (price-adjusted) broad trade weighted exchange rate index for the period 1990 to 2008. The broad trade weighted exchange rate index is a weighted average of the foreign exchange value of the U.S. dollar against the currencies of a broad group of major U.S. trading partners. An increase reflects an appreciation of the U.S. dollar. Current account and GDP data are presented on a quarterly frequency and the broad exchange trade weighted index has been averaged for each quarter based on monthly data. Data on the U.S. current account and GDP come from the Board of Governors of the Federal Reserve System and data on the broad trade weighted exchange rate come from the Bureau of Economic Analysis.
Figure 2 presents gross inflows to the United States by foreigners and by U.S. residents, considering only long-term securities (excluding bank flows). Gross inflows by U.S. residents are calculated as the negative of gross outflows, which are gross purchases of foreign stocks and long-term bonds by foreigners from U.S. residents minus gross sales. Gross inflows to the United States by foreigners are calculated as gross purchases of long-term U.S. Treasury and Federal Financing Bank bonds and notes, bonds of U.S. government and federally sponsored agencies, and U.S. corporate bonds and stocks minus gross sales. Data are presented in millions of U.S. dollars for the period 1990 to 2009 on a monthly frequency and come from the U.S. Treasury Department.