GLOBAL IMBALANCES Notes for Discussion Guillermo Calvo October 20, 2005

“Here's what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies (...). In other words, we've developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end.” Major Advocates: Krugman; Obstfeld & Rogoff; Roubini & Setser; Eichengreen Paul Krugman Hard Landing Hypothesis

USA External Deficit Financing Reflow of Private Capital to EMs Current Account (billions of US dollars) Crisis in EMs “Neoclassic” Period Private Financing Official Financing Source: WEO

31% 24% 20% 7% 3% 0% 5% 10% 15% 20% 25% 30% 35% ChinaJapanRest of Asia*Middle East** Latin America 15% Others International Reserves Accumulation Prima Facie, Asian Central Banks... Who is Financing the Current Account Deficit of the US? % 57% 71% 88% Reserve Accumulation in US Dollars Reserves in US dollars over total reserves, average : 63% (in % of the US Current Account deficit, 2004) *Includes: Korea, Hong Kong, India, Indonesia, Malaysia, Philipines, Singapore, Taiwan y Thailand. **Includes Oil Producers: Bahrain, Iran, Kuwait, Oman, Qatar, Saudi Arabia, Syria, United Arab Emirates and Yemen.

How Do They Do It?

 Non-US central banks buy US Treasury bonds by issuing their own debt to:  Private sector, or  Other banks who use private sector deposits.  Thus, directly or indirectly, private investors lend to US government!!

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% How was International Reserve Accumulation Financed? 2003 Senioriage Revenues in % of International Reserve Accumulation JapanKoreaChina Fiscal Deficit In % of GDP Japan Korea China %1.5% 7.9%6.7% 1.7%2.0%

What If Asia Floats? (Krugman’s concern)  If Asia floats, then Asian central banks stop buying US public bonds,  and, therefore, the private sector will buy US public bonds directly, instead of indirectly (as before).  Thus, if private sector demand for public sector bonds remains unabated (a reasonable assumption), Krugman need not worry...  Unless, of course, political and other considerations generate high market volatility.

Moreover  Interest rates on long-run US public bonds are not unprecedentedly low, and  The US public sector is not heavily indebted, compared with other industrialized countries.  The private sector savings have already undergone a large increase.

-6,0 -4,0 -2,0 0,0 2,0 4,0 6,0 8,0 10,0 12,0 Jan-55Jan-57Jan-59Jan-61Jan-63Jan-65Jan-67Jan-69Jan-71Jan-73Jan-75Jan-77Jan-79Jan-81Jan-83Jan-85Jan-87Jan-89Jan-91Jan-93 Jan-95 Jan-97Jan-99Jan-01Jan-03Jan-05 US Interest Rates: A Long Run View ( real interest rate, 10-year US Treasury Bond, Jan-55 – Jun-05 ) Average: 1.8 Average:

Public Debt in Industrialized Countries (Central Government, in % of GDP) 160% 101% 53% 40% 39% 37% 0% 18% 36% 54% 72% 90% 108% 126% 144% 162% 180% JapanItalyFranceGermanyUKUSA US Public Debt is Still Small

US Twin Deficits: Ricardian Equivalence? (In % of GDP) -6.0% -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% Mar-90Mar-91Mar-92Mar-93Mar-94Mar-95Mar-96Mar-97Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03Mar-04Mar % -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% Current Account Fiscal Result Current Account Fiscal Result Post EMs Crises Post US Recession

The Changing Anatomy of the US External Imbalance Savings & Investment Private and Official Current Account (% of US GDP)

Assessment  The current imbalances are sustainable, even if non-US central banks stop buying US public debt obligations, if private sector propensity to buy public sector bonds remains largely unchanged.  Given current low interest rates, Emerging Markets will become magnets for capital flows.  This may give rise to higher investment and growth in EMs but  given their small size compared to the US, this trend will likely have little impact on interest rates,  unless the US fiscal deficit shows no downward trend

GLOBAL IMBALANCES Notes for Discussion Guillermo Calvo October 20, 2005