“The Global Financial Crisis of the late 2000s, whether measured by the depth, breadth, and (potential) duration of the accompanying recession or by its profound effect on asset markets, stands as the most serious economic crisis since the great depression” (Reinhart and Rogoff, 2009).
The historical events that led up to this ‘Great Recession' can be said to be a symptom of historically low interest rates that were kept down for too long; as well as financial innovation into complex derivatives which was spurred on by financial globalization and technological improvements. A whole new buffet of financial instruments became available leading to a situation whereby credit became easily available to almost anyone giving rise to the ascension of sub-prime mortgages. Lack of regulation and on the premise of rating agencies, banks started lending excessively on mortgages creating an asset bubble larger than any in history.
Even though the origins of the crisis can be traced to the sub-prime market in the US, it is certainly impossible to fully understand the deeper underlying causes of the financial crisis without taking a look at the whole global dimension. The international aspect brings to light profound glitches in the international financial system - the global imbalances which indirectly have been a fundamental factor in creating the stepping stones that led to today's financial turmoil.
The focus is centered around China and the US because in the last decade, China has accumulated the largest foreign exchange reserve in the world and is the main contributor to the global current account surplus. Concurrently, the US has been running chronic trade deficits accounting for majority of the global deficit. The excess savings by the Chinese have been directed towards the American economy through purchase of government securities. Ironically, a crisis that has been termed a ‘credit crunch' in actuality emanated from excessive credit flowing from China and other surplus countries. The upshot of a world awash with cash resulted in downward pressure on global interest rates which allowed a mountain of leverage to spiral out of control.
This essay aims to explore the extent to which global imbalances precipitated the events that led up to the credit crisis. Section II provides an overview outlining the proximate causes that led to the eventual meltdown of the global financial system. Section III explains the magnitude of the global imbalances in recent years and why it poses such a problem. Section IV evaluates why they were allowed to continue without correction and how the international financial system actually aided their growth. Section V links the immediate causes to global imbalances denoting that they were one of the major underlying causes of today's crisis. Section VI suggests policies firstly to reduce global imbalances and to ensure that a situation like the present can be avoided in the future.
“There is merit in keeping alive the memory of those days. For it is neither public regulation nor the improving moral tone of corporate promoters, brokers, bankers, and mutual fund managers which prevents these recurrent outbreaks. It is the recollection of how on some past occasion, illusion replaced reality and people got rimmed” - Galbraith (1992).
Commenting on the distasteful events of the great depression of 1929, Galbraith urges us to keep the memories alive of how bad things can get. To heed the lessons of past mistakes. One way to ensure that ‘this time really is different' is to analyze what really happened, tracing every cause to its root which would then allow us to make the fundamental changes required to strengthen and stabilize our ever evolving financial global economy.
In the midst of the most serious economic crisis since the Great Depression, people are wondering how we could let this happen again. There is enough blame to go around from the legendary chairman of the Federal Reserve, Alan Greenspan and his miracle weapon of low interest rates to greedy bankers and CEOs. People question why the central bank and world renowned economists with all their forecasting tools could not prevent the huge housing bubble which grew at unprecedented rates. The very existence of regulators and rating agencies is being challenged as people ponder why orthodox banking was discarded in return for new lending practices such as the originate-to-distribute model using opaque financial derivatives leaving the whole banking system vulnerable. Or is it that greed being an inherent human trait will every so often emerge and threaten to devastate the very foundations of our capitalist system. In reality, there is no one single cause, but rather a toxic concoction of all these factors put together which formed a boom and bust of unimaginable consequences for the whole global financial system.
The origin of the credit crisis has been commonly attributed to defaults in the sub-prime mortgage market. In layman terms, sub-prime lending is simply providing high interest loans to individuals with weak credit histories (Atlas and Dreier, 2007). The concept first came about in the 1970s when President Jimmy Carter took steps to open up the mortgage market to ethnic minorities. The policy however was not meant to be used by exploitative bankers on the ‘hunt for yield' but rather as a politically attractive stance for justice to fulfill the great American dream of home ownership. The desire to provide low income Americans with mortgages was later aggressively pursued by both the Clinton and Bush administrations (Pym and Kochan, 2008). Figure one shows that in the period from 2001 to 2006, sub-prime mortgages increased by 275% constituting one-fifth of all mortgages (Blackburn, 2008).
One of the major factors that allowed for subprime mortgages to spiral out of control and induce irreparable damage was the US housing bubble which borrowers used as collateral for accumulating unwarranted levels of debt. House prices first started escalating due to volatility in the stock market during the unraveling of the dotcom bubble which shook the faith of millions who then resorted to investing in the housing market as a safe alternative (Baker, 2008). Fear of recession from the stock market crash and the 9/11 attacks spread like fire causing Alan Greenspan to react by slashing interest rates till they stood at only 1% (Brummer, 2009). The combination of low interest rates, ‘irrational exuberance' , and cheap credit which infiltrated the economy from surplus countries such as China and oil exporting economies (which I will discuss in more detail later) caused the housing market to boom to unparalleled levels (See Figure 2).
On the pretext of seemingly ever increasing house prices, lenders and borrowers alike became complacent with a somewhat euphoric attitude believing that the days of the natural economic cycle of boom and bust were over. Traditional lending practices had been completely forgotten and a whole new array of exotic mortgages were now available all designed to entice borrowers, especially sub-prime. Loans were being given out requiring little or no documentation (‘no doc'). ‘Liar loans' required no assessment of credit or income histories and ‘jumbos' were loans given out which were disproportionate to the borrowers income (Brummer, 2009).
Lenders were not overly concerned with the risk of default because from their point of view, as long as house prices continued rising they were not at a loss. If mortgage payments became too high, which they most likely would due to bankers' dubious lending practices , the borrowers could always take out a home equity loan or sell the property to pay off the mortgage (Krugman, 2008).
However, unable to defy the law of gravity, the housing market eventually peaked and started to descend by mid 2005. As house prices began descending, they became harder to sell. Defaults started becoming regular and the weaknesses of sub-prime lending emerged with alarm bells ringing for investors and borrowers alike.
What amplified the situation further and infiltrated worldwide financial systems was the craze of new fangled complex financial derivatives which attracted investors from all over the world. Spurred on by a drive to earn higher profits in the face of low interest rates, bankers started securitizing housing mortgages (including subprime) into mortgage backed securities (MBS), bundling them up and then reselling them. Formally known as the originate-and-distribute model which was thought of as less risky as assets were being bundled up with a wide range of other assets, some of which with low default risk such as ‘prime' mortgages (BoE Quarterly Bulletin, 2009). This allowed banks and mortgage companies to take on more and more debt as these institutions started playing ‘pass-the-parcel' thereby moving the securitized loans off their books and transferring the risks to other investors whilst making handsome profits (Lim, 2008). Another exotic variant of securitization included collateralized debt obligation (CDO) which consisted of packages of loans with differing risk ratings (senior, mezzanine and equity) and maturity dates. Increasing demand for these new instruments ultimately led to even more aggressive sub-prime lending (Pym and Kochan, 2008). At the same time, the process of securitization lead to a ‘shadow banking system' whereby Special purpose vehicles (SPVs) were created to grant banks the ability to invest using these assets however from a distance i.e. they were not required to appear on the balance sheet. This provided the advantage of being able to expand their lending without worrying about capital requirements (Mizen, 2008).
Many other risky derivatives such as credit default swaps (CDS) and Leverage-buy-outs (LBOs) were also being exploited in the name of diversification and spreading risk. However these innovative forms of investment in the words of Warren Buffet turned out to be “financial weapons of mass destruction” (BBC NEWS, 2003). More than half of the MBSs and CDOs were sold off to foreign banks who believed in the reputation of the American and British financial institutions (Pym and Kochan, 2008). So when house prices started falling and sub-prime mortgages started increasingly defaulting causing an explosion in the very instruments that were supposed to ‘spread risk', there was a devastating ripple effect that was felt all over the world.
“The golden decade had given way to hubris” while ignorance prevailed regarding risk and common economic sense. In Charles Kindelberger's words, the panic stage had arrived following the manic stage of fanatic investments into the complex financial derivatives that none but a few elite understood (Haldane, 2009).
In hindsight, one could question why so much faith was put into these risky derivatives. Mizen (2008) points out that the chief reason can be accredited to the over reliance on rating agencies whose job was to predict the likelihood of default on the products in question. Due to the complexity in apprehending the complex Asset-backed securities (ABSs), many investors relied on the ratings provided by companies such as Moody's, S&P's and Fitch who believed that pooling many individual sub-prime loans would have a reduced risk of default when combined into a package. They therefore granted many MBSs and CDOs with AAA ratings (equivalent to government debt default in a developed nation) making the products seemingly very safe.
A major flaw of the rating agencies can be ascribed to the principle-agent problem whereby the rating agencies' incentives were driven more by greed because they were earning huge up-front profits for providing top-ratings to the securities. They justified their actions with the short-sighted notion that house prices would keep on rising therefore chances of default were low anyway (Swanson, 2008).
The story of the events that led up to the great recession fit nicely into Hyman Minsky's Financial Instability Hypothesis where he postulated that the financial economy becomes ever more fragile over a period of prosperity. During the boom, firms reaped high profits from taking on more debt which encouraged other firms to follow suit creating a deeper hole of indebtedness (Whalen, 2008).
While the trigger may have been caused by the sub-prime mortgage debacle and the housing market crash, it was the sheer magnitude of investment fuelled from unprecedented levels of debt into the complex financial instruments with a thumbs-up from trusted rating agencies that struck the core of the global financial system.
Moving on from the financial practices, we examine the deeper underlying structural causes of the bubble which are based on the controversial global imbalances that were spurred on by financial globalization. The correlation between global imbalances and the current crisis is still hazy at best. Some scholars claim that there is no link and attribute all blame to the regulators and bankers whilst others are increasingly looking for a deeper cause claiming that the increasing global imbalances in the last decade, especially between the largest deficit country, America and the largest surplus country, China is indeed a fundamental factor.
In the Aftermath of the Asian Financial Crisis of 1997, a transformation in the structure of the global financial system laid one of the vital stepping stones for the current economic crisis - the rise of financial globalization. This meant that the tendency for ‘home bias' was dramatically reduced. Investors were increasingly investing in other countries which was considered as being less risky as they would not be affected dramatically if their home country was to suffer from an economic slump. Between 1996 and 2007, American assets overseas as a percentage of GDP increased from 52 percent to 128 percent whilst liabilities increased from 27 percent to 145 percent. Emerging economies used this form of ‘decoupling' from industrial economies to accumulate massive reserves in order to protect themselves from future currency crisis and then used the proceeds to lend back into the American economy. In the words of Stephen Jen, the chief currency strategist at Morgan Stanley, the ‘hard lending' may in fact prove to be the ‘second epicenter' of the global crisis (Krugman, 2008).
In essence, a trade imbalance represents the difference between national savings and domestic investment (Cooper, 2006). The advantage of being able to run either a trade deficit or surplus stems from the concept of consumption smoothing through intertemporal trade. A country would be able to borrow funds from foreigners in times of economic distress to avoid sharp contractions in consumption and investment. Conversely, countries with abundant savings may lend to earn higher yields on investment projects overseas (Obstfeld and Rogoff, 1996).
According to Gruber and Kamin (2005), economic theory suggests that industrial nations should be net exporters of capital to developing nations due to their higher labor/capital ratios. Furthermore, developing nations have more of an incentive to borrow against higher future income to try catch-up with their western counterparts. However in recent years, the situation has shifted dramatically to the contrary whereby emerging economies have switched from being net importers of capital to net exporters.
The substantial imbalances in savings and investment which mostly emerged after 2000 were echoed in the growing current account imbalances represented above in Figure 3. Since the dismantling of the Bretton woods system in 1973, the US has suffered from a continuous trade deficit which gathered momentum from 2002 onwards, peaking in 2006 at 6.2% of GDP (McKinley, 2009). Concurrently, for various reasons, net savings outside the US started rising dramatically from 1999 onwards. Japan as well as oil exporters such as Germany and Russia contributed significantly to the overall global surpluses but none as much as China (IMF, 2008, cited by Corden, 2008). By 2007, China's surplus was the largest in the world standing at a whooping $262 billion which was 11 percent of its GDP (see Table 1). Most of that surplus in actuality ended up being lent to the US. In essence, the People's Bank of China (PCB) took on the role of becoming a personal “banker to the United States of America” (Ferguson, 2008).
% of GDP
Source: IMF World Economic Outlook, April 2009
Current account imbalances can be broken down into three sections constituting net private capital flows, net official capital flows as well as changes in international reserves. Figure 4 below demonstrates that throughout Developing Asia, the rapid rise of international reserve accumulation has been a key spectacle. The reasons are accounted for by both the rapid rise in current account surpluses as well as large net private capital inflows i.e. a dual surplus (Adams and Park, 2009). Again, China is the ring leader in international reserve accumulation, announcing in 2009 that it had crossed the milestone of $2 trillion accounting for 30 percent of total foreign exchange reserves worldwide (Prasad and Sorkin, 2009)
Before the onset of the current crisis, the widening trade gaps between surplus and deficit countries had already prompted heated discussions as to whether these global imbalances were sustainable and what the future implications would be.Some scholars with the likes of Cooper (2007), Caballero, Farhi and Gourinchas (2008) and Mendoza, Quadrini, and Rios-Rull (2007) deduced that the global imbalances were simply a by-product of increased financial integration due to globalization. They claimed that these threats were in fact benign because in their eyes, the American financial system was void of flaws and thereby able to take on high levels of leverage without risk (Obstfelf and Rogoff, 2009).
However, some economists did acknowledge the dangers global imbalances posed for the future of the financial system. They argued that continued widening imbalances would eventually lead to a forced dollar depreciation as external claims on the deficit countries would eventually catch up on them (IMF, April 2009). Also sharing concern, Federal Reserve chairman Ben Bernanke noted that “the risk of disorderly adjustment in financial markets always exists, and the appropriately conservative approach for policymakers is to be on guard for any such developments” (Bernanke, 2005).
Predictions of the forced disorderly dollar depreciation did somewhat start to materialize during the early stages of the crisis. Between June 2007 and July 2008, the dollar fell 8.5 percent in real effective terms as news of the shady sub-prime and MBS investments spread throughout the economy unleashing fear and panic. However the difference occurred because this did not cause additional flight from US assets and hence a massive drop in the dollar as economists had previously expected. Instead, as subprime mortgage defaults escalated into a global pandemic creating widespread fear of financial turmoil, investors sought refuge in U.S. government securities thereby strengthening the dollar (IMF, April 2009).
Considering the discussion of the threat global imbalances poses has been an ongoing affair for quite a few years, one could question how and why these imbalances were allowed to go on for so long without correction. This section examines the basis of these imbalances which are fundamental to understand before delving into the depths of how they precipitated an abundant supply of credit and hence depressed interest rates.
Part of the global imbalance story can be explained by structural and macroeconomic factors such as demography, inequality or the existence of a welfare state. But the main underlying reason can be found in the intricacies of the international financial system that allowed countries to pursue policies that facilitated the rapid growth of these imbalances. The establishment of Bretton Woods after the Second World War primarily allowed two features to surface that played a pivotal role in the imbalances. The first feature is that a country that issues reserve assets can finance its current account deficit over a prolonged period of time. The second feature allows a country to manipulate its exchange rate in order to limit appreciation of its currency creating distortions in trade and capital flows (Dunaway, 2009).
One major critique as to why the US had such a large deficit is attributable to its savings rate which has been diminishing over the last three decades. Figure 5 shows that in 2005, personal savings as a percentage of disposable income was the lowest since the Great Depression reaching only 0.8%. The US national savings rate which includes corporate savings as well as government budget deficit stood at 13.6 percent of GDP which was also a post-war low (Mandel, 2005).
One of the preeminent explanations of the low savings rate can be disclosed by the state of the economy which had been doing exceptionally well deeming the period “the great moderation” whereby unemployment as well as inflation was low and on the whole wealth was rising. The wealth effect arose at first from high equity prices followed by an upward trend in housing from 2000 onwards. Bernanke (2005) analyses that between 1996 and 2000, the American stock market had been on an upward progression and was therefore considered a safe and profitable investment. Furthermore, due to the advantageous American financial reputation, investment into these equities became much more attractive to international investors. This therefore led to an overwhelming flow of Capital into the US financial system resulting in an even higher appreciation of stocks and the US dollar. Rising stock prices created a wealth affect leading to decreased incentives on savings as well as increased consumption especially on imported goods which become relatively cheaper due to the strong dollar.
During the unraveling of the dotcom bubble, equities took a sour turn and investors looked towards the housing market for safety. Since 70 percent of Americans own their home and with house prices increasing from year to year by about 6.4% between 1990-2006 to reach almost $58 trillion, homeowners felt invincible. Financial innovation in that decade also made it possible to increase liquidity of home equity. Such innovations included home-equity loans and reverse mortgages making credit available to repay other consumer debt; to buy consumer durables such as automobiles and household furniture; or even to finance a vacation (Cooper, 2007). This exogenous transmission is the main factor as to why savings and therefore the trade deficit in the US started deteriorating dramatically from 2000 onwards. Sarno, Juvenal and Fratzscher (2007) back up this theory with findings using a Bayesian structural vector autoregressive (VAR) model. Their empirical findings indicate that housing and equity price shocks are of considerable importance, accounting for about 32 percent of trade movements in the US current account at a horizon of 20 quarters.
Cooper (2007) further explains that home equity accounted for extensive wealth beyond basic requirements, so the tendency for older US householders to bequeath some of their wealth to their offspring increased. The expectation of this inheritance further dampened some of the younger generation to save in anticipation of a future source of income.
Finally, another substantial reason as to why American savings is considerably lower than most third world economies is the existence of a welfare state which incorporates publicly financed social security. Mostly all American retirees are guaranteed up to $23,000 annually from the age of 66 onwards.
While it is appropriate to say that on the whole, America's savings was declining especially compared to the highly prudent Asian economies, it was a secondary reason as to why the US deficit was so high. The elementary reason is because foreign investment into the US is large. Table 2 shows that between 2004 and 2007 with the exception of 2005, over $1 trillion poured into the economy each year.
The chief reason for the influx of credit can be accredited to the development of the issuance of reserve assets which was an important development for a rapidly expanding international system. The definition of a reserve asset is an external asset that is readily available and whose control falls under the authorities with respect to direct financing of international payments imbalances (OECD, 2001). In recent years, the primary issuer of reserve assets, America has taken this feature for granted by financing its huge and growing deficit through issuance of its assets in its domestic currency, namely its government securities. Financing the deficit became relatively cheap and easy for the US since foreign countries were more than willing to accept low yields on risk-free government securities. The huge scope of US government securities made investments from foreign countries much more attractive especially considering the securities are highly liquid with low volatility thereby meeting the criteria perfectly. In ordinary circumstances, there would be a limit to the magnitude of US assets that a foreign country would want to hold. However due to the lack of close substitutes for US dollar assets, most of the savings from emerging economies had been directed towards the US putting even more downward pressure on securities. Figures 6 and 7 show that as the US debt rose, yields on government treasury bonds were falling, hence making borrowing even more alluring (Dunaway, 2009).
Conceding that the world was awash with money that was mostly directed towards the US creating a large deficit, the focus now turns towards the emerging economies, especially China. To determine why they had such a huge surplus in the first place and why they chose to direct their excess savings into the US.
The Chinese economy has been performing exceptionally well over the last two decades averaging a growth rate of around 10 percent per annum. Per-capita income has almost quadrupled in the last 15 years and some even predict that in time to come, China will overtake America and become the largest economy in the world (Hu and Khan, 1997). The growth strategy implemented originated from the successive model of the Asian Tigers whereby development was focused on investment in public infrastructure as well as the manufacturing sector thereby putting pressure on the savings rate to finance the investment (Wiemer, 2009). This is one of the main reasons as to why China's current account surplus skyrocketed almost quadrupling between 2002 and 2007. The rapid increase in the production of manufactured goods on the premise of an investment-heavy export orientated growth pattern resulted in production heavily outweighing domestic demand. At the same time, imports were humbled in part due to import substitution (Hofman and Kuijs, 2008).
Investment in China has indeed been very high reaching almost 40 percent between 1996 and 2004 which further rose up to 45 percent in more recent years. The problem in regards to the surplus occurred because savings in China has been growing faster than investment rates, escalating to 51.4 percent in 2008 which implies capital outflow and an analogous trade surplus (McKinley, 2008). The structure of savings (shown by the figure 8) in China has seen that corporate savings has increasingly become a key benefactor as well as household savings which rose by about 6 percent in the last 10 years (Chamon and Prasad, 2008).
High savings in China has been conceived as rational for a number of reasons. Firstly, Cooper (2006) outlines that China's savings is particularly receptive to demographic changes especially after its introduction to the one-child policy in 1979. Table 3 shows that between 2005 and 2025, the number of young entrants to be accounted for in the Chinese economy is estimated to fall by about 19 percent whereas America is estimated to see an increase of about 7 percent. In essence, there are fewer young adults entering the labor-force every year demanding less housing, schooling and education, thereby reducing the need for investment to safeguard the next generation.
Source: U.S. Census Bureau
Thus excess savings tends to be directed towards foreign investment to uphold profitability. This explains the pattern of reduced young entrants in economies coordinating with chronic current account surpluses reflecting their high levels of foreign investment.
The theory behind this is further supported by the Life-cycle Hypothesis introduced by Irving Fischer. It postulates that the savings rate will rise if young and elderly dependents in a population falls and if there is excessive income growth in an economy - both are true in the case of China (Wiemer, 2009).
However based on empirical evidence, Chamon and Prasad (2008) reject the life-cycle hypothesis as being the main force behind high savings in China. Their evidence shows that instead of a ‘hump-shaped' profile of savings over investment (consistent with consumption smoothing), they in fact found that the youngest and oldest generations have the highest propensity to save. Their explanation for savings trends centers around the changing economic climate whereby there was a decline in public provision for healthcare, education and housing facilities thus giving rise to precautionary savings. Before housing reforms took place, state enterprises often supplied housing to their employees. Since the move towards privatization, there has been a dramatic shift towards home ownership which stood at a measly 17 percent in 1990 rising to 86 percent in 2005. Another explanation provided for precautionary savings among Chinese citizens is the transition into a market economy creating uncertainty about economic conditions. The lack of a welfare state providing public provisions thus conveys a situation whereby younger cohorts need to save for education and housing, simultaneously elderly citizens need to save for future health expenditures.
In the case of China, precautionary savings can be understood as a rational response to the uncertainties brewing in their economy, however what is not readily explainable is why there was a rise in enterprise savings as well. One explanation is that despite high profits from companies, the constant inflow of cheap labour which is abundant in China has kept wages fairly low. The upshot being that company revenues minus expenditure has been gradually rising thereby increasing savings as well (Corden, 2009). Another slightly more cynical angle is that mangers and CEOs of companies tend to hoard a percentage of the profits rather than distribute the highest return to shareholders. They retain power over their shareholders through the threat of selling their positions and thus driving down the prices of shares which is ultimately not in the interest of anyone (Wiemer, 2009).
This represents just one angle showing how the trickle-down effect of high growth rates to low income earners is sorely lacking in China. In fact despite high growth rates, income inequality has worsened in the last two decades. The World bank estimated that the share of GDP to labor fell from 53 percent to 41 percent in the space of seven years up to 2005 (Lim, 2008). In 2006, it was estimated that over 150 million people still lived under less than a dollar a day and yet China is home to 345,000 dollar millionaires (Ferguson, 2008). The aspect of inequality is also a plausible explanation as to why savings are generally higher in China. Galenson and Leibenstein (1955, cited by Birdsall, 1996) postulated that due to the affluent having higher marginal propensities to save, a greater concentration of income results in higher savings and hence higher aggregate capital accumulation.
High savings certainly explains part of the reason as to why China's surplus was in overdrive. The fundamental factor however, stems from China's pursuance of export-led growth as well as their desire to accumulate foreign reserves.
Before 1997, Asian economies had undergone an investment boom which attracted torrents of capital inflows. When the boom turned to bust, investors globally retracted their money out of emerging economies causing a collapse in their currencies, bank insolvencies as well as a huge slump in GDP. This calamity revolutionized the thought process of authorities in emerging economies who were still writhing from the scars caused by the currency crisis. In response, authorities sought to accumulate large foreign exchange reserves in order to ensure that in the future, such financial instability of that nature would not overpower them (Bootle, 2009).
The incentive to accumulate reserves provided further impetus for China to aggressively pursue her strategy of export-led growth as well as curtailing imports. As illustrated by figure 9, by the 21st century, China's exports had started picking up momentum while imports had started slowing down.
As part of the package to increase exports, China adopted a managed exchange rate policy whereby they pegged their currency to the dollar. Normally, a continuous rise in exports over imports creating a surplus would eventually lead to a natural correction of the trade balance through upward pressure on the exchange rate. However, to safeguard their exports to keep them at competitive rates, Chinese authorities intervened heavily in the exchange market to keep their exchange rate from appreciating. (Corden, 2009).
Resisting pressures for exchange rate appreciation led to a speculative frenzy in anticipation of the RMB to eventually appreciate which meant that the country was the new target of capital inflows. To counteract the inflationary pressures on their exchange rate caused by the inflows as well as increasing exports, authorities implemented ‘sterilization' programs to inhibit credit growth. All the excess savings of consumers and enterprises naturally flowed into commercial banks at a time where they were attempting to restrict credit. This forced the state owned banks to buy PCB bills even though the rates of return offered were very low. Banks could not alternatively choose to increase their lending for instance, to corporate conglomerates because that entailed a capital requirement of 100 percent. In essence, sterilization was a money making scheme using the tact of ‘window guidance and moral suasion' to direct excess savings into PCB treasuries which were slyly amassing to become the largest reserve accumulation in history
Moreover, China's use of stringent capital controls was a methodology used to attract foreign direct investment however they restricted other inflows such as portfolio debt. This further added to China's trade surplus and hence foreign reserve accumulation (Prasad, 2008).
Obstfeld and Rogoff (2009) infer that without ‘sterilization' that kept the RMB from appreciating as well as expenditure compression policies, the natural international adjustment process would have weakened the dollar, interest rates would have been on the whole higher thereby insinuating a smaller US deficit.
The most efficient way for China to employ her excess capacity was to export manufacturing goods to the insatiable US consumer. The currency pegs certified that Chinese goods would remain highly competitive through the mechanism of buying billions of dollars on world markets, and hence keeping their currency undervalued. The outcome resulted in a two trillion dollar surplus which supported a large fraction of the US deficit. The arrangement was dubbed the ‘Bretton Woods II' system which allowed both China and America to benefit. China benefited insofar as it had access to a huge market in which to export its goods to maintain their rapid GDP growth. America could let the good times roll on by obtaining cheap credit through China's purchase of low yielding dollar reserve assets (Adams and Park, 2009). The unspoken agreement was seen as a positive sum game - ‘Chimerica' (Ferguson, 2008). Ultimately however, the excessive leverage that had accumulated had been taken too far setting the stage for the financial crisis to ensue.
In retrospect, a different view of global imbalances emerged questioning not how they caused the crisis but rather the role they played in building systematic risk in the run-up of the crisis. How Global Imbalances played a vital part in determining interest rates and large capital inflows into the US which in turn had a multiplied effect leading to higher levels of debt, a ‘hunt for yield', the creation of riskier assets which all culminated in the catastrophic housing bubble of the 21st Century (IMF, April 2009).
The imbalance of savings over investment in emerging economies as discussed above gave rise to the so-called ‘savings glut' which was a hypothesis first popularized by Ben Bernanke in 2005. He explains in his Sandridge Lecture that excess savings from the emerging economies, especially China are the main culprit for depressed global interest rates which in turn led to a further widening US deficit and tremendous asset price inflation.
According to Desroches and Francis (2007), in an increasingly financially integrated world, global interest rates are determined by the interaction of desired savings and investment. As well as the reasons explained in the previous section as to why savings in emerging economies have been on a rise, in the years proceeding 2000, Bernanke (2005) argues that in the aftermath of the dot-com bubble bust, desired investment dwindled worldwide inducing an imbalance of savings over investment. De facto, as shown by figure 10, long term interest rate did actually fall, more so from 2000 onwards to near historic low levels to equilibrate the market for global savings.
Bernanke was not the only one to share this opinion, as Niall Ferguson (2008) in his Ascent of Money comments, “Chinese imports kept down US inflation. Chinese savings kept down US interest rates. Chinese labor kept down US wage costs. As a result it was remarkably cheap to borrow money…Global interest rates - the cost of borrowing after inflation - sank by more than a third below their average over the past fifteen years…The Asian ‘Savings Glut'…was the underlying reason why the US mortgage market was so awash in cash in 2006 that you could get 100 percent mortgage with no income, no job or assets.”
Many have criticized Bernanke for his ‘savings glut hypothesis' by claiming that he was simply deflecting blame away from the Fed for keeping US short term interest rates low over a prolonged period of time. Boeri and Guiso (2007) go so far as to exclaim that without Alan Greenspans's low interest rate policy, the crisis might not have occurred.
Furthermore, during the years of the great moderation, Taylor (2008) argues that there was in fact decreased volatility in the financial system due to a more fine tuned monetary policy system based on the Taylor rule which aided in taming inflation and thereby reducing interest rate volatility. However, between 2003 and 2006, the fed rate was substantially below the guidelines of the Taylor rule. Using a counterfactual scenario, Taylor shows that if the Fed rate had followed the Taylor rule, smoothed to have the 25 basis point increment adjustments, then house prices would not have risen so drastically implying that the financial turmoil would not have been so deep.
However, Corden (2008b) construes how interest rates in actuality had to fall in reaction to the world savings glut which would have otherwise led to deflation resembling the Japanese debt trap. One of the objectives of monetary policy is to ensure initial employment and inflation rate stay constant, creating an “internal balance”. In a normal circumstance, economic theory would dictate that an increase in savings would lead to a deflationary threat. Fear of the US economy falling into a Japanese style debt deflation trap befittingly forced the Fed to implement expansionary monetary policy to maintain internal balance.
In the above Hicksian IS-LM diagram, (r) represents the real rate of interest and (Y) is the real income or output. The initial equilibrium point would be where LM0 (real money supply) intersects the IS0 (Level of income for any given interest rate) curve represented by point A. An increase in net savings would shift the IS curve to the left (IS1). If interest rates stayed fixed, then the economy would be in danger of deflation as equilibrium would fall to point B. However, in reality, interest rates are flexible and determined by the Fed. If they chose not to respond, equilibrium would have been at point C which means output and hence employment would have fallen. Therefore the only rational choice for the fed, given their commitment to internal balance was to increase money supply shifting the LM curve to the right (LM1).
Historically low long term interest rates along with an accommodative loose monetary policy is the match which “ignited the conflagration.” First off, it got the ball rolling for financial innovation into opaque derivatives as bankers itched for new ways to reap profits due to low returns (Bean, 2008).
A change in the pattern of behavior of investment bankers becoming more risk tolerant due to low interest rates is explained by Rajan (2006). He explores the concept of “risk shifting” claiming that when interest rates are very low, insurance companies are compelled to take on more risk either directly or through alternative investments. For example, if an insurance company promises premium holders a return of 8 percent, however the matching bond term rate falls to 3 percent, then the broker has no option but to “hunt for yield” to try hold true on his promise by delving into more riskier investments. An alternative scenario involves hedge funds themselves. Normally, the return on a compensation contract for a head fund manager would be 2 percent of assets under management in addition to “20 percent of annual returns in excess of a minimum nominal return.” If risk free returns are low then the fund manager would have a strong incentive to take on more risk as otherwise his compensation may not even exceed the minimum return. Furthermore, in times of prolonged low interest rate with the expectation of them to remain low, investors are more likely to borrow funds to gain higher profits due to the low cost of borrowing.
The second effect of historically low interest rates was its multiplied effect on the housing market causing a massive drop on mortgage rates in the US. Along with the subprime craze, this encouraged more investment into the housing market leading to tremendous house appreciation (which was already on an upward trend). Consumption, commodity prices and borrowing soared as optimism infiltrated the economy further dampening US savings thereby leading to an even greater US deficit. Moreover, along with real estate prices, residential investment also started to boom providing impetus to borrow even more sums of money (mostly from China) to fund their deficit (Obstfeld and Rogoff, 2009).
The low cost of borrowing and the appreciation of the housing market has a two way relationship whereby “housing appreciation fuels increased borrowing from abroad in several ways, whereas increased availability of foreign funds could ease domestic borrowing terms and encourage housing appreciation” (Obstfeld and Rogoff, 2009).
Further backing up this correlation, Aizenman and Jinjarak (2009) estimate the correlation between the current account deficit as a percentage of GDP and house appreciation increases using a sample of 12 countries. They find an increase of .041 percent annually for all 12 countries - .029 percent for OECD countries and .036 percent for non OECD countries. Figures 12 and 13 show this relationship whereby an increase in the current account deficit as a percentage of GDP is affiliated with real estate appreciation.
They derived this estimation by regressing real estate prices on the lagged current account as well as other macroeconomic variables for the 12 countries between 1998 and 2007. They included in their panel estimation the current account deficits/GDP with a maximum of five lags and other macro variables (Financial depth, real interest rate, urban population growth) with one lag.
Yet according to this rationale, since current account deficits are affiliated with housing appreciation, it would be logical to assume that countries with current account surpluses would experience a trend of falling house prices. However, even though China's current account surplus was rising dramatically from 2006 to 2008, figure 14 shows that house prices were also rising in that time frame.
Though there is sound rationale for the correlation between global imbalances and low global interest rates, it is important to note that substantial global imbalances are a relatively recent phenomenon, whereas global interest rates have been gradually falling since the 1990s. Desroches and Francis (2007) argue that from 1989 onwards, an investment dearth in the global markets is a more plausible explanation as to why global interest rates in general have been falling.
The great recession has highlighted the inherent flaws of the current growth patterns prevailing in our economy which are based on excessive dependence on foreign demand. It is therefore important to recognize the short term and medium term policy objectives for policy makers.
Recent statistics on trade patterns have shown that the crisis has brought about an improvement in trade imbalances. However, these improvements are merely a by-product of temporary protectionist measures undertaken by economies in the face of instability and uncertainty. Baldwin and Taglioni (2009) expound that there has been an unprecedented slump in world trade aroused by a synchronized drop in demand. Figure 14 shows that as a consequence, countries with chronic deficits such as the US are importing less and surplus economies with the exception of China have scaled back their exports due to lack of demand resulting in an overall reduction in the trade imbalance.
However due to the nature of the collapse in trade which was not rooted in policies directly addressing these imbalances, it is highly probable that as world demand picks up, world trade will also bounce back up thus restoring the imbalances.
Considering the role global imbalances have played in fostering the financial meltdown, it is of vital importance to incorporate the issue along with economic stimulus and financial market regulation to ensure a stable and enduring recovery. Agreeing with this consensus, US treasury secretary, Henry M. Paulson Jr. stated:
“If we only address particular regulatory issues - as critical as they are - without addressing the global imbalances that fuelled recent excesses, we will have missed an opportunity to dramatically improve the foundation for global markets and economic vitality going forward. The pressure from global imbalances will simply build up again until if finds another outlet” (Dunaway, 2009).
The key components to reduce the global imbalances would be to firstly reduce the surplus of China and other emerging economies by reducing savings as well as reducing their reliance on exports by boosting domestic demand. Secondly, America would have to implement policies to increase their savings. A global problem can be corrected if there is global coordination with help from an international body such as the IMF to oversee and ensure that the necessary changes are indeed enforced.
Many have ascertained that allowing the RMB to appreciate is an integral part of reducing its growing surplus through an overall reduction in exports. Using an ‘underlying balance' approach, Goldstein (2006) predicted that for China to equilibrate its overall balance of payments, the RMB would have to appreciate by roughly 20 to 35 percent against the dollar to induce the required negative swing in its current account. One of the most cited adjustments needed to be made by Chinese authorities is to allow exchange rate flexibility which would appreciate the currency on impact and ease pressure off from Chinese authorities who in recent times have been declared as ‘currency manipulators.'
The issue of currency intervention and sterilization programs is the most damaging aspect for the prospects of permanently reducing China's surplus to sustainable levels. The reason authorities cannot simply apply a one-off appreciation is because China's underdeveloped financial system would not be able to sustain the shock smoothly. Therefore the first step in gradually ascending to a free floating exchange rate system would have to first off address banking reforms. Privatizing banks and allowing for natural competition and free market forces to prevail will help reduce financial instability in the economy. Only once macroeconomic stability is achieved can authorities look to appreciating the currency and thus move towards an eventual free floating system.
However, empirical analysis from Wei (2008) shows that in actuality, there is no evidence linking flexible exchange rates and convergence in the current account towards a steady state equilibrium. A perfect example is the case of Japan between the years of 1971 to 1990. The end of the Bretton Woods fixed exchange rate regime saw the Japanese yen more than double against the US dollar making their exports less competitive and imports cheaper. Despite this phenomenon, the Japanese current account surplus still shot up from $6 billion to $80 billion (DeWeaver, 2008).
Instead, the most beneficial path to reduce China's current account surplus is to implement a package of reforms which are aimed at gradual appreciation and at weaning off growth patterns reliant on exports. Policies should then look inward, focusing on boosting domestic demand. This would have the advantage of realigning the main drivers of growth such that consumption rather than exports becomes a higher contributor to GDP. Higher domestic consumption would also explicitly imply a reduction in savings which is also a fundamental factor.
In this regard, authorities could embark upon a large fiscal stimulus that would increase public provision in healthcare, education as well as providing social security. The safety provided would dramatically reduce precautionary savings by all cohorts. Fiscal stimulus could also allow a diversification from manufactured products towards a tertiary sector which would gradually reduce export reliance. The eventual result of increased job availability in different sectors such as tertiary as well as a more skilled workforce through education stimulus would be the first stages in boosting domestic consumption.
To reduce high savings from enterprises, it is essential to acknowledge the issue of inequality. Since China has an excess capacity of labor, wages generally tend to be kept suppressed leading to increasing profits for firms. Implementing a minimum wage and introducing more labor equality to ensure profits are proportionately distributed would ensure a higher trickle-down effect reflecting productivity growth as well as higher consumption due to a rise in income.
As the process of financial globalization continues, China's pursuance of policies and its economic conduct will have an even larger influence on world markets. Its huge and growing surplus and massive accumulation of reserves could again be the reason for creating financial instability and aid another financial crisis in the future. Therefore it is imperative for China to start laying the stepping stones that will allow for a permanent reduction in surpluses.
One mechanism by which the US trade deficit is predicted to reduce through market forces is rationalized by Feldstein (2008). He explains that some relatively large banks have in fact disclosed that they intend to diversify their portfolios by reducing their share of dollar assets held (IMF, 2009). Therefore as foreign exporters such as China obtain dollars through selling their goods to the US, instead of adding the dollars to their dollar reserves, they will instead seek to sell. However if there are not any willing buyers at the prevailing exchange rate, the dollar will be forced to depreciate until it becomes more attractive again which would make exports relatively cheaper and imports more expensive thus reducing the trade deficit. Feldstein further explains that in the past, countries that wanted to amass large dollar reserves to protect themselves kept the dollar strong. Now, having amassed the needed reserves, they will opt to sell their dollars rather than accumulate them further. Therefore there will be a natural move away from the dollar being the principle issuer of reserve assets leading to a smaller US deficit.
Nevertheless, even with a depreciating dollar and a move away from the US being the principle issuer of reserve assets, a fundamental requirement for a lower deficit has to focus on increasing the US national savings rate. This would allow the US to finance its investment through increase in savings rather than borrowing from emerging economies and accumulating unwarranted levels of debt. As part of the recovery package, America has been forced to implement an aggressive fiscal stimulus to attack high levels of unemployment as well as restoring faith in the economy. A further deepening of the government deficit implies that more pressure will be put on household savings to pick up the slack. Theoretically, the Fed would increase interest rates to increase savings in the economy. However, given the fragility of the economy, it would be unwise to enforce deflationary tactics before the economy is stabilized and confidence in the economy is restored as this could lead the economy back into recession.
In the medium term, policies aimed at increasing savings will require restructuring of the tax system. Friend (1985) states that there is evidence showing that a redistribution of the tax burden from lower income groups to higher income groups may stimulate the aggregate propensity to save. One method to achieve this is to reinstate the top marginal income earners' tax rates of the 1990s which was abolished by the Bush administration.
However, given that the main source of the increase in household savings was attributable to the wealth effect, an increase in household savings is likely to occur without any specific change in government policy. Declining house prices as well as equities which due to lack of confidence in the economy are not likely to return to levels enjoyed in the earlier part of this decade. At the same time, sharp increases in regulatory oversight which is a top priority for the banking sector ensures that the availability of housing equity through borrowing will fall. A fall in the wealth effect explicitly implies that consumers will spend less and save more (Feldstein, 2008). Indeed, the US has embarked upon an era of thrift. The New York Times reported that in the last three months of 2008, the US personal savings rate hit its highest level in the last six years (Healy, 2009).
A global problem unquestionably requires global cooperation. For global imbalances to achieve an equilibrium that is optimal for the global economy, China and America must work together. Pursuance of policies that are seemingly only best for their domestic economies will only exacerbate the global imbalances further.
Global adjustment requires substantialeffective depreciation of the dollar andappreciation of the Asian currencies. Thetrade-weighted exchange rates of the euroand sterling vis-a-vis their main partnersdo not need to change, but this does notmean that bilateral exchange ratesagainst the dollar should not move.Although adjustment would see the euroand sterling depreciate against currenciesin Asia, European currencies would need tostrengthen further against the dollar, to atleast $1.45 per euro and to well over $2per pound. Policymakers in Europe shouldnot resist appreciation of their currenciesversus the dollar so long as it is matchedby depreciation against the yen and therenminbi and happens in the context of aglobal currency adjustment.Agreement on the substance of apolicy-induced adjustment is thepurpose of the multilateral consultationsat the IMF initiated in2006.
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