It is a pleasure to be here at
the Reserve Bank of India and to follow so many distinguished economists in
giving this year’s L. K. Jha Memorial Lecture.
It has been six years since I was
last in India and more than 15 since I first came. The changes have been remarkable
-- in the economy, in the financial system, in education and health care --
and as a consequence, there has been vast improvement in the lives of literally
hundreds of millions of people. And the change in India’s relations with the
United States has been a profoundly positive development – one that I hope and
trust will prove lasting.
This all is a tribute to many people
and many things. Thinking back to that moment in the summer of 1991 when India
was on the brink, it is a tribute to the resolute determination and extraordinary
wisdom of those who have guided India’s finances. It is a tribute to this great
institution, the Reserve Bank of India. And it is a tribute to successive Indian
governments and to the enormous thoughtfulness of Indian economic discourse
on almost every subject.
As remarkable as developments in
India have been, they are not my primary subject this evening. Instead, I want
to focus on some implications -- both positive and normative -- of what is to
me the most surprising development in the international financial system over
the last half dozen years. That development is the large flow of capital from
the world’s most successful emerging markets to the traditional industrial countries,
and the associated enormous buildup of reserves in the developing world. To
my knowledge it was neither predictable nor predicted and the implications are
large and have not yet fully been thought through.
The Current Global Capital Flows
Three aspects of global financial
flows stand out as being without precedent:
First, the net flow of capital
is substantially from developing countries and emerging markets towards the
industrialized world and principally the United States as the world’s greatest
power is the world’s greatest borrower. Figure 1 depicts global current account
balances as estimated for 2005. It is apparent that the United States is overwhelming
absorber of global savings while the rest of the world is a supplier of global
savings. While the combined current account surpluses of Japan and the non-European
industrialized countries represents about 35% of US net international borrowing,
the remainder is financed overwhelmingly by emerging markets and oil exporting
countries. This broad pattern, which has been going on for several years now
and on current projections will continue for quite some time, runs very much
counter to the traditional idea that core countries export capital to an opportunity
Second, the buildup in U.S. net
foreign debt is substantially mirrored in reserve accumulation by emerging markets.
While claims flow in many directions, it is noteworthy that a large fraction
of the buildup in foreign claims is represented by reserve accumulation. Brad
Setser, whose regular web log on this topic should be a resource for all concerned
about these issues, estimates that global foreign reserves, netting out valuation
adjustments increased by $670 billion in 2005, of which Japan accounted for
only $15 billion. As Figure 2, drawn from Setser’s work, illustrates, this pattern
of substantial foreign reserve accumulation has been underway for several years
though there has been a shift from Japanese accumulation of reserves to increased
accumulation by oil exporters.
As I shall discuss in substantially
more detail later, global reserves of emerging markets are far in excess of
any previously enunciated criterion of reserve need for financial protection.
Figure 3 uses one familiar criteria, the so-called Guidotti-Greenspan rule that
reserves should equal 1 year’s short term debt to demonstrate the spectacular
increase in what might be thought of as excess reserves in emerging markets.
These reserves have grown from half a trillion dollars in 1999 to over two trillion
dollars today. As Table 1 demonstrates, they are distributed quite broadly around
Third, expected real returns on
these reserves are very low. Assuming constant real exchange rates, reserves
will earn the expected real return on primarily Dollar and secondarily Euro
fixed income assets. Indexed bond yields or comparisons of interest rates and
forecasted inflation rates would make 2% a somewhat optimistic estimate of expected
real returns in international terms. If real exchange rates in emerging markets
are likely to appreciate then domestic returns will be even lower and more risky.
These three elements, flow of capital
from emerging markets to industrial countries, huge accumulation of reserves,
and expected negative returns on reserves constitute what might be called the
capital flows paradox in the current world financial system. While borrowing
and consuming is functional for the United States and reserve accumulating and
exporting is perhaps functional for many other countries, the sustainability
and the desirability of the capital flows paradox seems to me to require careful
thought. Let me turn first to the American situation.
Unsustainable and Problematic Dependence
of the United States on Foreign Capital.
The American current account deficit
is unprecedented in our economic history or that of other major economic powers.
Today, it is currently running at a rate approaching 7% of GDP. Barring some
discontinuity, most knowledgeable observers expect it to increase. Imports substantially
exceed exports, the dollar appreciated over the last year, the income elasticity
of U.S. imports exceeds that of U.S. exports, and so forth. International debt
accumulation at these rates cannot go on forever.
Moreover, most of the classic indicators
for deciding how serious a current account deficit are worrying.
- First, 7% and growing is an unusually large
deficit, as Figure 4 illustrates.
- Second, as Figure 5 illustrates, the current
account deficit is financing consumption rather than investment as the U.S.
net national savings rate is now at a record low level of under 2%.
- Third, investment is tilted towards real estate
and the non-traded goods sector rather than the traded goods sector and
away from exportables.
- Fourth, the net flow of direct investment
is out of the United States and the flow of incoming capital appears to
be of shortening maturity and coming increasingly from official rather than
This configuration, whatever its
causes, raises obvious risks. There is the hard-landing risk. This is not just
an American risk, but a global risk at a time when the U.S. external deficit
is creating nearly a export stimulus demand approaching 2% of global GDP. And
as we are seeing with increasing frequency, whether it is regarding ports or
computers or automobile parts, the current situation is creating substantial
protectionist pressures. In addition, it is hard not to imagine that there are
geopolitical risks associated with reliance on what might be called a financial
balance of terror to assure continued financial flows to the United States.
Indeed, I was reminded about the geo-political issues that such dependence posed
for the United States when I read recently about the effective American use
of exchange rate diplomacy to force the hands of the British and French during
the Suez crisis.
To be sure the United States should
be viewed differently from an emerging market and so there has been a certain
amount of complacent commentary – commentary that has gained in strength as
the U.S. current account deficit has continued without evident ill effect. In
general, my view thinking about past experience with tech stocks in the United
States or with the Japanese stock market or with a range of emerging market
situations is that the moment of maximum risk comes precisely when those concerned
about sustainability lose confidence in their views as their warnings prove
to have been premature and when rationalizations come to the forefront.
I will not reflect at length on
the commentaries of the complacent. Suffice it to say that intangible investment
as well as tangible investment in the United States has also declined in the
United States even as our dependence on foreign capital has increased. Even
if home bias is declining, there are surely limits on the tolerance of foreign
investors for increased claims on the United States. And while arguments about
';financial dark matter'; or the U.S. ability to issue debt in its own
currency probably have some force in thinking about what level of external debt
is sustainable for the United States, they surely do not make the case for indefinite
continued expansion of debt.
U.S. Adjustment and the Global
The massive absorption of global
capital by the United States is of questionable sustainability and if sustainable,
of dubious desirability. But the one thing that we all know about markets is
that they have two sides and that one cannot understand U.S. borrowing without
understanding foreign lending. One cannot understand U.S. deficits without understanding
others’ surpluses. And one cannot think through the consequences of reduction
in U.S. import led growth without thinking through the consequences for the
export led growth of others. Let me turn then to the global economic configuration.
As have been conventional in many
international discussions, it is frequently suggested, sometimes even in India
that the U.S. is sucking capital out of the developing countries because of
its fiscal deficit. Yet one has to worry about getting what one wishes for in
the form of a unilateral U.S. increase in national savings.
There is one striking fact about
the global economy that belies a dominantly American explanation for the pattern
of global capital flows: real interest rates globally are low not high. Whether
one looks at index bond yields, measures of nominal interest rates relative
to ongoing inflation, and yields on most assets, especially real estate or credit
spreads, capital market pricing points to the supply of global capital tending
to outstrip demand rather than vice versa. Real interest rates globally are
low not high from a historical perspective. If the dominant impulse explaining
global events was delincing U.S. savings, one would expect abnormally high real
interest rates, as with the twin deficits in the 1980s, not abnormally low real
interest rates. America’s consumption growth in substantial excess of income
growth has been matched by substantial export led growth in the rest of the
Imagine that somehow through some
combination of U.S. policy adjustments, U.S. national savings were to substantially
increase resulting in downwards pressure on U.S. interest rates and a sharp
reduction in the U.S. current account deficit. The result would be a substantial
contractionary impulse to the remainder of the global economy, an effect that
would be magnified if other currencies appreciated against the dollar causing
a switching of expenditure towards U.S. goods. Moreover, those countries seeking
to peg their currencies as U.S. interests rates declined would have to further
expand not just their reserves but their rate of reserve accumulation. An unwinding
of global imbalances, if it is not to be recessionary for the global economy,
thus requires compensatory actions in other parts of the world. What are these
As a matter of arithmetic,
any reduction in the U.S. current account deficit must be matched by reductions
in current account surpluses or increases elsewhere. If this simply takes place
automatically as a consequence of reduced U.S. demand the result will be contractionary
on a substantial scale. After all, the U.S. current account deficit represents
an impulse of close to 2% of GDP to global aggregate demand. What compensatory
actions are appropriate? It is conventional to start such a discussion with
the industrialized countries. But as Figure1 illustrates, their surpluses offset
less than a quarter of the U.S. current account deficit.
Japan at last appears to be recovering,
though as is all too traditional, its growth appears to be export led. Unfortunately,
given Japan’s fiscal situation and the structural reality of a ageing society
and shrinking labor force it’s not clear just how much scope there realistically
is for a shift to domestic demand led growth.
The situation in Europe is
in some ways less clear. Some European policy makers have taken the position
that since Europe is in approximate current account balance, it has no major
role to play in the global current account adjustment process. They urge U.S.
fiscal contraction as a means for reducing the U.S. deficit but do not see any
European movement into deficit as part of the global adjustment process. I find
this view implausible. As long as there are going to be substantial structural
surpluses in the oil exporting countries, it is hard to see why Europe, which
is even more dependent on imported oil than the United States should not be
comfortable running at least a modest current account deficit. Moreover there
is scope for both microeconomic policies that reduce regulator barriers and
macroeconomic policies to increase aggregate demand.
Without the gift of prescience
regarding oil prices, it is harder to prescribe for the oil exporting countries.
The accumulation of significant current account surpluses in the face of a transitory
increase in the price of oil seems rational and appropriate. And the long experience
of natural resource exporters, including the experiences of oil exporters during
the 1970s suggest the dangers of being too quick about assuming that price increases
will be permanent. There is a likelihood that over the next several years either
oil prices will come down or oil exporters contribution to global aggregate
demand will increase. But in prescribing a path for overall global adjustment,
caution is surely in order here.
The net surplus of emerging Asia
led by China exceeds the combined surplus of Europe and Japan. And given the
magnitude and attractiveness of investment opportunities in emerging Asia it
would be natural for it to run a current account deficit. This suggests that
the primary source of global demand to offset increases in United States savings
should come from the Asian consumer. India is a positive example here. It is
noteworthy that consumption represents close to two thirds of GDP in India,
and significantly under one half in China. I will return in a few minutes to
the question of reserve accumulation and to the potential for shifting to a
more domestic demand led growth strategy in emerging markets.
In addition to the benefits for
the global system, that a domestic demand led strategy would bring, I suspect
a less export oriented strategy would also contribute to ultimate financial
stability. Looking back, it seems relatively clear that Japanese economic policy
could wisely have supported more consumption sooner and in the process avoided
the bubbles in asset prices during the 1980s associated with preventing Yen
appreciation that created such havoc in their financial system.
The rest of the world is probably
not in a position to make large contributions to the global adjustment process.
Healthier policy environments in Latin America and Africa would reduce capital
flight, tend to increase private capital flows and lead to somewhat larger investment
driven current account deficits. Given the current euphoria reflected in emerging
market spreads, it would be a mistake for policy makers to cheer this process
along too rapidly.
The Opportunity Cost of Excess Global
So far I have argued first
that the U.S. current account deficit is unsustainable and dangerous, and second
that managing its decline will require substantial adjustments in other parts
of the world if a recession is to be avoided. I want to return now to the question
of official reserve accumulation of which I referred to earlier.
It is striking to estimate the
cost to developing countries of reserve holding that goes beyond what is necessary
for financial stability. Even if we used a standard more rigorous than any that
has been proposed and treated reserves in excess of twice short-term debt as
unnecessary for insurance purposes, these reserves, as shown by Figure 6, represent
almost $1.5 trillion and are growing at several hundred billion dollars per
year while earning what is likely to be a zero real return measured in domestic
terms. This represents a substantial cost. If the wealth tied up in reserves
were invested either domestically in infrastructure or in a fully diversified
long-term way in global capital markets, 6% would not be an ambitious estimate
of what could be earned. The resulting gain would be close to $100 billion a
year. Aggregating the 10 leading holders of excess reserves, the opportunity
cost of these reserves comes to 1.85% of their combined GDP.
As Dani Rodrik has pointed out,
this is comparable to the gains thought to be achievable from the next round
of trade liberalization, to global foreign aid, or to spending on key social
sectors in a number of countries. This idea of an excess of low yielding reserves
in the developing world represents a radical departure from the problems that
we have traditionally focused on in thinking about the international financial
system. From the founding of the IMF to the creation of the SDR through discussions
of expanded SDRs during the 1990s, the emphasis was on the need to find low
cost ways of manufacturing insurance that reserves could provide capital importing
developing nations. It is a very different world when developing nations are
accumulating reserves to finance the United States.
Towards a Revised International
The two new elements in the global
financial constellation that I have been stressing – the U.S. current account
deficits mirrored primarily by surpluses outside of the traditional industrialized
nations, and the staggering accumulation of reserves by emerging market countries,
both suggest the obsolescence of the G7/G8 as the dominant forum for international
financial discussion. It is neither in a position to discuss many of the most
important domestic policy adjustments necessary for global stability nor does
it include the largest official suppliers of cross border flows of capital.
The G7/G8 Finance Ministers process was started at a time when major issues
of global demand and policy coordination involved only the industrial countries
– when exchange rate policies were largely a matter of concern between industrial
countries and when the only issues involving developing countries were periodic
breakdowns in the flow of capital from rich country lenders to poorer country
borrowers. None of these premises are currently met.
Any attempt to manage jointly any
increase in U.S. savings and an offsetting increase in global demand from global
sources will clearly require a forum broader than the G7/G8. So also will any
global attempt to think through the implications of the massive reserve accumulation
on which I have commented.
Just what process is right for
addressing these issues is a delicate and sensitive political question involving
aspects that I am no longer close to. There has been an explosion of financial
fora involving emerging markets in recent years, including the APEC finance
ministers, the Latin American finance ministers, the ASEAN finance ministers
and most promisingly, the G20. It may well be the appropriate successor to the
G7/G8, though I worry about just how much serious business will get done in
a forum with 40 principals. What should not be in doubt is the importance of
creating a forum that structurally has political clout over the international
institutions and at least some ability to influence domestic policy decisions
of individuals countries. I would suggest three areas of focus in the next several
First and most importantly, the
formulation of a global strategy for managing the U.S. current account deficit
downwards without excessive risk to global growth. I do not minimize the domestic
difficulties in the United States here, nor am I falsely optimistic about the
ability of any international forum to influence U.S. fiscal policy. Nonetheless
I believe that much more frequent and intense discussions on a multilateral
basis than have taken place to date will raise the prospects for a successful
adjustment process and reduce the risks of either a hard landing or of dangerous
unilateralist responses to current account imbalances.
Second, a new forum should look
at the role and governance of the existing international financial institutions
in the current environment. Clearly, the influence and governance of the major
reserve accumulators need to be increased. More fundamentally, the IMF
has always had as its raison d’être addressing imbalances, but its surveillance
and indeed its lending has always been focused on those who are borrowing excessively.
I used to quip that IMF stood for ';It’s Mostly Fiscal';, though the
fund’s work in recent years has expanded much more broadly. But it must be acknowledged
that the energy it devotes to current account deficits that need to be adjusted
downwards dwarf the energy it addresses to current account surpluses that need
to decline to facilitate smooth global adjustment or the energy it devotes to
encouraging current account deficits where these can finance either consumption
on attractive terms or productive investments.
In a similar vein, the IMF has
perhaps been too reluctant to criticize the exchange rate policies of its members.
When exchange rates are overvalued, the IMF does not point it out publicly for
fear of creating a panic. When exchange rates are undervalued, the IMF often
does not see financial problems for the country in question and so does not
raise an alarm. It has always struck me as ironic that the IMF, which is charged
with maintaining the global financial system and therefore should be particularly
focused on policy choices that affect multiple countries, is prepared to address
domestic monetary and fiscal policy choices, which while they may have international
ramifications are primarily of domestic concerns, but is so reticent about addressing
exchange rate issues which by their very nature are multilateral. It is unlikely
that the IMF will take on this role alone and so will very much need the encouragement
of its major shareholders.
Third, the group should take up
the question of deploying the reserves of developing countries. There are of
course the questions that are much discussed of the potential implications for
the international financial system of shifts in the composition of currencies
in which reserves are held. This is obviously a sensitive subject for everyone,
but as long as the ex ante returns on dollar assets and euro assets are relatively
close together it may not be a matter of welfare significance.
Of greater concern is the risk
composition of the assets in which reserves are invested. When reserves were
held at levels that represented self-insurance against possible financial crisis,
the case for their investment in maximally liquid, maximally safe form was compelling.
When reserves are far greater there would seem to be a case for more aggressive
investment either in support of imports that have a high social return or in
a much richer menu of international assets.
By investing in a global menu of
assets U.S. institutions have earned substantial real returns over the years.
Indeed the average large higher education U.S. endowment fund has earned a real
return approaching 10% over the last decade or two. It is natural to ask whether
the excess national reserves of emerging markets should not be invested with
an aspiration in this direction.
If India, for example, were to
follow this course, the result would be extra returns that would amount to between
1 and 1 1/2 % of GDP each year. This figure, which dwarfs the seigniorage considerations
that traditionally played so large a role in monetary theory, represents an
amount greater than Indian public sector spends on health care each year. Annuitized
and valued as a stock it is comparable to 40% of the market value of all the
traded stocks on the Bombay Exchange. And India is not an extraordinary case.
Reserves as a share of GDP are actually very substantially larger in China,
in Taiwan, in Russia, and in Thailand than in India.
In principle decisions about reserve
investment can be made domestically. But I suspect that there are at least two
important roles for international discussion and coordination. There are important
risks for any central bank that attempts to go in this direction. It is likely
to reap much more disfavor in years where investments go badly than favor in
years when investments go well. And the opportunities for mischief in picking
assets, in exercising control rights, in misvaluing assets are likely to be
very large. Some form of legitimated international scrutiny and monitoring of
central bank reserve investments could help to overcome these problems.
Perhaps it is time for the IMF
and World Bank to think about how they can contribute to deploying the funds
of major emerging markets rather than lending to major emerging markets. More
ambitious than simply providing surveillance and monitoring that would support
most ambitious investments by emerging markets would be the creation of an international
facility in which countries could invest their excess reserves without taking
domestic political responsibility for the process of investment decision and
If such a facility was able to
attract even a limited fraction of excess reserves and to charge even a relatively
modest fee, the sums of money available to support the concessional and grant
aspects of global development would be significant. For example, globalizing
$500 billion at a fee of 100 basis points would produce $5 billion a year that
could go towards global public goods, multilateral grant assistance or debt
There are many problems here. As
we have found with state pension funds in the United States any large investor
cannot completely escape political issues. There is the question of how central
bank profit contributions to government budgets should be handled when returns
vary. There are issues of assuring integrity. I don’t minimize any of these
difficulties which might prove insuperable.
But it is an irony of our times
that the majority of the world’s poorest people now live in countries with vast
international financial reserves. The problem for these countries is not being
supported in borrowing from abroad – and so it seems appropriate that some part
of the focus of the international financial architecture move towards the challenge
of deploying their large reserves as effectively as possible.
Just as India’s remarkable
development over the last fifteen years comes with both great opportunities
and challenges, so too the dramatic changes in the pattern of global capital
flows come with remarkable challenges and opportunities. I don’t think any of
us have the answers. I will have served my purpose today if I have induced you
to reflect on the future of a global economy increasingly defined by a large
flow of official lending from developing nations to the world’s largest and