5 The Damocles’ word of external imbalances According to the IMF, the US current deficit will stand at 6% in 2006 and 2006; for the OECD it will reach 7% The counterpart to the US deficit are substantive surpluses in Asia, the EU and oil exporting countries. A dollar depreciation will cause a wealth loss abroad, aggravating the negative effect on aggregate demand
6 Taking a closer look at the US current account imbalances 1995 – 1999: the rise in investment is partly offset by a concomitant increase in saving 2001-2004: the investment rate falls, but saving drops even more Hence: foreign saving helped finance the technology led investment boom in the first period. Nowadays, it supports mainly the rise in private and public consumption
8 What’s behind the current account surplus in emerging Asia? in Japan? in China? in oil exporting countries?
9 In emerging Asia the current account surplus after 1998 reflects a major drop in investment
10 Also in Japan the fall in investment (the red line) is the main factor behind the rise in the current account surplus
11 While in China the strengthening of the current account balance reflects mainly the rise in saving (the blue line)
12 Finally, in the oil exporting countries.. the oil price bonanza has so far been associated with a rise in the saving rate (the blue line), while the investment rate is still lagging behind
13 Why are real interest rates so low? A saving glut? –Saving went up only in China and in oil exporting countries. –Even there, the increase in saving may not last long A drop in investment? –Investment fell in Japan, emerging Asia and in the oil exporting countries –In (most) cases, though, the fall in investment may be temporary A portfolio reallocation effect? –Again, a temporary phenomenon?
16 Has fiscal policy become irrelevant? In the eighties real interest rates responded sharply (from 0% in 79-80 to 6.9% in 84-85) to fiscal imbalances. In the early 2000’s the interest rate response is almost muted. In Europe, domestic spreads seem to be little affected by fiscal indiscipline
17 Real interest rates and debt ratios in Europe
18 The pessimist’s perspective Fiscal indiscipline is no longer associated with higher interest rates, presumably because of greater global financial integration However, low global real interest rates mainly reflect temporary phenomena, such as unusually high saving rates in China and oil producers and low investment rates in other areas Moreover, individual countries with a high and rising debt may suffer relatively more from tighter financial conditions
19 European countries with a large and rising debt face higher spreads
20 Who is more vulnerable? The rise in interest rates will add to the burden of high public and foreign debt countries The increase in interest rates may lead to a rise in the level of spreads: –Greater risk of financial distress –Greater risk aversion by markets participants The rise in the debt ratios may further boost countries spreads
28 The outlook today Growth is unlikely to pick up on a sustained basis Inflation is higher than in the rest of the EU: the standard adjustment mechanism does not work for Italy Slow growth and lack of fiscal restraint have resulted in a significant deterioration of the budget
30 An unpalatable combination Taken together, low growth, real appreciation, rigid markets, high debt ratios and large fiscal deficits are a cause of concern Structural reforms in the product markets and in the educational system should loom high in the policy agenda Fiscal consolidation should come soon before interest rates start rising