An important feature of the global monetary regime of the last three decades is the imbalance in the distribution of current account balances across countries and country groupings. Recently, the most glaring discrepancy is the fact that a huge US balance of payments deficit is being substantially financed by developing countries and not largely by the surpluses of other developed countries or the surpluses in the oil exporting countries.
Consider 2007, for example. While Japan and Germany are two large surplus earners, the surpluses of these two countries accounted only for 30 per cent of the aggregate surplus of all surplus earners. Even among these two, Germany’s net current account surplus of over $263 billion is implicitly being absorbed by deficits in other countries of the Euro area, since the deficit of the Euro area as a whole is estimated at $137.5 billion in 2007.
The corollary is that developing countries and countries in transition have become important sources of surpluses to finance the US deficit. If we take the top ten developing and transition economies in terms of the size of their surpluses, their aggregate surplus accounts for 95 per cent of the US deficit. If we leave out oil exporters and take the top 10 among the remaining developing countries, their surpluses account for 72 per cent of the US deficit. China’s surplus alone accounts for 51.1 per cent of the US deficit.
Taking developing countries as a group, we find that the period since the mid-1990s has seen a transformation of their current account deficits into surpluses. While this was true initially of a set of countries in Asia, they have since been joined by countries in West Asia, Africa and Latin America, though not Central and Eastern Europe. Developing and emerging market countries outside Developing Asia have also been recording a surplus as a group, because of the contribution made by oil exporters in West Asia.
Financing the US Deficit
In fact, these developing countries have been even more important from the point of view of financing recent increases in the US deficit. The $602-billion increase in the US current account deficit between 1996 and 2007 was not matched by surpluses in the other industrial countries as a whole, although some individual industrial countries did record increased surpluses.
The collective current account of the industrial countries worsened from a surplus of $28 billion in 1996 to a deficit of $366.4 billion in 2008, implying that the increase in the US current account deficit was not offset but added to by deficits in other industrial countries. The bulk of the increase in the US current account deficit was balanced by changes in the current account positions of developing countries, which moved from a collective deficit of $109 billion to a surplus of $492 billion — a net change of $601 billion — between 1996 and 2007.
There are two sources of accretion of surpluses in the balance of payments of the developing countries, epitomised by China and India. In China’s case, these surpluses have been substantially “earned” in the sense that they reflect its export success and a surplus on the current account of its balance of payments. This has been added to with inflows of foreign direct investment and, more recently, foreign portfolio investment.
In the case of India on the other hand, its surpluses have been “borrowed”, in the sense that they accrue because small deficits or small surpluses on the current account of its balance of payments in recent years have been accompanied by huge inflows of capital, especially portfolio capital. If capital inflows are largely borrowed and are of the portfolio kind, the pressure to accumulate reserves is greater, because of the danger that these flows could be reversed, as happened in South-East Asia in late 1990s.
There is another reason why a significant, even if not dominant, part of the recycling of these surpluses to the US occurred through the central banks of these countries. Under liberalised exchange rate regimes, large dollar inflows (whether due to surpluses on the current or capital account) exert an upward pressure on the domestic currency of the country that receives those foreign exchange inflows, raising the value of the domestic currency against the reserve currency.
To prevent such appreciation and shore up the competitiveness of the recipient country’s exports, the central bank steps in to stabilise the currency to buy and mop up the excess foreign exchange. This results in the accumulation of large reserves. Data from the US Federal Reserve relating to US government agency bonds held by foreign official institutions shows that they increased by $119 billion in 2007, although in the wake of the crisis in 2008 they fell by $31 billion. In the first seven months of 2009, they fell by another $31 billion.
However, not only was the contribution of non-oil exporting Asian countries even more significant, it actually continued to be positive even in 2008. Thus, Asian holding of US public bonds increased by $131.6 billion in 2007 and $32.4 billion in 2008, while the corresponding figures for China and Hong Kong taken together were $103.7 billion and $40.3 billion. Even in the first seven months of 2009, total Asian holding of US government bonds remained largely stable, with a small increase of $2.3 billion by West Asian oil exporters and a small decline of $2.5 billion for all other Asian countries.
What is important to note here is that while it is the profligacy of the United States that is resulting in the huge deficit on its balance of payments, the deficit country is not the one making the adjustment to correct for global imbalance.
This is quite contrary to the experience of developing countries who find themselves in deficit and are forced to undertake painful adjustment measure to reduce their own deficit.
Instead, in a remarkable reversal, the countries accumulating surpluses, whether “earned” or “borrowed”, are the ones making the adjustment. They continue to invest their surpluses in safe and liquid international securities among which US Treasury securities predominate. And that adjustment is not without cost. Large reserves create huge problems for monetary management, and central bank efforts to sterilise foreign exchange reserves to manage money supply have adverse implications for fiscal policy. Moreover, the returns received on reserves invested by central banks are much less than the returns earned by those who bring the foreign exchange into these countries in the first place.
This current and evolving international monetary conjuncture is quite directly related to the shift in policy regime in favour of less regulated and more market-friendly regimes across the world, as we have argued in earlier editions of MacroScan. One consequence of the neo-liberal policies associated with that shift is, for example, the increased reliance on exports as opposed to domestic markets for fuelling growth. This has meant that countries that successfully pursue mercantilist, export-led strategies, as China has done, record current account surpluses.
In a system of market-determined exchange rates, this threatens an appreciation of their currencies that could reduce export competitiveness. To prevent this, they accumulate foreign exchange reserves to prevent appreciation, in turn necessitating the investment of these surpluses in safe assets. Much of this investment moves to the home of the reserve currency, where the value of the assets is presumed to be more stable.
Besides, neo-liberal fiscal reform imposes fiscal conservatism and deflationary fiscal practices, which have balance of payments effects that imply either a reduction of current account deficits or the emergence or increase of current account surpluses.
Neo-liberal policies also contribute to the accumulation of surpluses through the liberalisation of rules governing capital inflows in the form of foreign direct and portfolio investment, besides foreign borrowing. Liberalised foreign direct investment rules help attract relocative foreign capital seeking low cost locations for world-market production; that links direct investment flows with exports, as happened in the past in the second-tier newly industrialising countries in Southeast Asia and more recently in China.
Liberalisation of rules relating to foreign portfolio investment and debt flows result in large inflows on the capital account, as has happened in India in recent years. In both cases, the effect is to force the central bank to mop up the some of the foreign exchange that flows in, so as to prevent the domestic currency from appreciating. Large foreign exchange reserves are a corollary.
Finally, neo-liberal policies also involve the liberalisation of rules governing the outflow of capital in the form of investments by residents abroad. The pressure to liberalise these rules is the greater the larger are reserves with the central bank.
Once the degree of “capital account convertibility” is increased, capital tends to flow through private as opposed to official channels from developing countries to the developed in general and the reserve currency country in particular. This contributes to reserve accumulation as in other cases. It also increases the pressure to accumulate reserve to guard against the reversal of capital flows that could follow any surge in inflows.
These consequences of liberalisation contribute in no small measure to the global imbalance that is otherwise rooted in the uneven development characteristic of capitalism. In sum, today’s imbalance is directly linked to the shift to a neo-liberal regime. It also strengthens the position of the reserve currency in two ways.
First, it creates an influential constituency of those who are uncomfortable with a depreciation of the dollar, because this would undermine the competitiveness of exporters supplying the US from countries whose currencies are appreciating vis-à-vis the dollar and also reduce the value of dollar-denominated financial assets in which governments and wealth holders from the rest of the world have invested.
Second, a depreciating dollar may encourage deflationary policies or protectionist responses in the US to reduce the deficit in the US balance of payments, and this (combined with its continuing domestic recession) reduces its ability to serve as the engine for growth in the rest of the world economy.
Thus the conjuncture created by a combination of uneven development and neo-liberalism is partly responsible for the persistence of the dollar as the world’s reserve currency.
C.P. Chandrasekhar is Professor at the Centre for Economic Studies and Planning at Jawaharlal Nehru University. He also sits on the executive committee of International Development Economics Associates. Jayati Ghosh is Professor of Economics at the Centre for Economic Studies and Planning at Jawaharlal Nehru University. Chandrasekhar and Ghosh co-authored Crisis as Conquest: Learning from East Asia. This article was first published in the Hindu Business Line on 20 October 2009; it is reproduced here for non-profit educational purposes.