Global Policy Forum

IMF Issues a Warning, But Are the US and China Listening?


By Tim Colebatch

The Age
October 13, 2007

Country A is borrowing a net $2 billion a day from the rest of the world — which seems odd to many, since it is not in obvious need. Country B is lending a net $1 billion a day to the rest of the world — which seems odd to many, since it has obvious needs around every corner. For years, the International Monetary Fund, financial institutions and investors have been worrying about the sustainability (let alone the wisdom) of these flows. What will happen to the world if they stop? What will happen if they don't stop?

The IMF has been highlighting the risks for years. Its managing director, Rodrigo de Rato, has convened a joint study of current account imbalances to try to get the US, China, Japan, the Europeans and the oil exporters to act to reduce their imbalances: the US by reining in its budget deficit, China by making its exchange rate more flexible, Japan and Europe by increasing the pace of reform. But his success has been limited. Now the IMF has broadened its attack with a new analysis which, in effect, warns China that its regime to hold its exchange rate below market value is likely to fail, and warns the US that unless it gets its fiscal house in order, it risks an even harder landing when the capital flows stop.

The warning comes in one of three chapters from the IMF's new World Economic Outlook, published in the lead-up to next week's annual meetings of the IMF and the World Bank in Washington. A second chapter analyses similarities and differences between the rapid growth of the 2000s and that of the 1960s. It argues that while this growth has been more widespread and consistent than in the past, the transition from '60s boom to '70s bust shows us that things can go wrong unless policies adapt to fresh challenges. A third chapter concludes that inequality is rising in Western countries along with growth, but offers modelling that shifts the blame from globalisation to technology, arguing that low-skilled workers' wages are being held down by competition from machines more than from workers in other countries.

The impact of the subprime mortgage crisis will be dealt with in next week's chapters. But IMF economic counsellor Simon Johnson reaffirmed that it expects the world economy will ride over this bump. "The immediate impact on global growth should be modest," Dr Johnson said. "As I see it, the repercussions are likely to be contained within the advanced economies, and the global expansion should continue, albeit at a somewhat slower pace. In (developing) countries we expect expansions to remain broadly on track. Nevertheless, short-term risks have clearly risen." Three weeks ago the IMF's half-yearly report, Global Financial Stability, highlighted an extraordinary increase in global financial integration — and risk.

On one hand, it said, global capital flows remain upside down, flowing from poor countries to the rich rather than vice versa. Of all net capital inflow in the world in 2006, almost 60 per cent was soaked up by the United States, and 20 per cent by four other rich countries — Spain, Britain, Italy and Australia (which had 3 per cent of net inflows). And where is it coming from? China, with all its needs, was by far the world's biggest capital exporter, providing 17.3 per cent of net outflows, well ahead of Japan (11.8) and Germany (10.1). Five oil and gas exporters — Saudi Arabia, Russia, Kuwait, the United Arab Emirates and Algeria — provide another 20 per cent.

On the other hand, investors' appetite for risk has risen steeply. The notional amount owing on global derivatives markets grew from $US258 trillion ($A286 trillion) at the end of 2004 to $US415 trillion at the end of 2006. That's roughly 8.5 times the world's gross domestic product. A pile-up on the derivatives racetrack could be nasty for the world. But the risk is not just in derivatives. Gross capital flows into emerging markets in the first half of 2007 far exceeded those in all 2006. As the IMF sees it, this is not unwelcome in itself; except in Eastern Europe, most of it is flowing into countries (such as China) which have current account surpluses and strong foreign reserves (especially in developing Asia, where foreign reserves now average 7 per cent of GDP, making currencies impregnable against speculators.) And that is what the IMF wants them to stop doing. Analysing 100 periods of large capital inflows into countries, and their aftermaths, it says they show that:

  • Attempts by countries to prevent real exchange rate appreciation by intervening in currency markets may work at first, but history suggests they fail eventually.

  • Countries that receive large foreign capital inflows can shield themselves from a seriously hard landing when the flow stops by applying fiscal restraint, rather than spending on a scale that assumes capital inflows will last.

    > "The last 20 years suggest that capital flows always do stop at some point", Dr Johnson said. "What really helps in sustaining growth after the capital flows stop is being careful. A country experiencing high capital inflows needs to exercise fiscal restraint. Otherwise, it risks overstimulating the economy through boosting domestic demand, and exacerbating overheating pressures that raise the risk of a hard landing." The IMF's argument is similar to one aired frequently in Australia by some economists. Federal Government spending increased by almost 30 per cent in the four years to 2006-07. In its report on Australia last month, the IMF stopped short of criticising this, but emphasised: "With the upcoming federal election, it will be important to keep economic policy from deviating from its medium-term objectives."

    The IMF's concern is the US, where the 2008 election rules out any serious attempt to rein in the budget deficit before the next administration in 2009. In a chapter on the changing business cycle, it adds that while the global economy in the 2000s has enjoyed strong growth that is more widespread and less volatile than ever, that does not mean the business cycle is dead. "The abrupt end of the period of strong and sustained growth in the early 1970s provides a useful lesson about what can happen if policies do not adjust to tackle emerging risks in a timely manner," it warns. But are Washington and Beijing listening?

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