IMF's stern surplus warning

Lowy Interpreter

In the years leading up to the 2008 global financial crisis, many commentators identified substantial current account deficits and surpluses as the main danger to the world economy. In particular, they worried about the US deficit and the Chinese surplus. As things turned out, neither of these imbalances was central to the GFC. Conversely, the intra-euro imbalances, which are at the heart of the current euro crisis, were largely ignored.

The International Monetary Fund has recently analysed the current state of play. The GFC reduced the biggest deficits, largely because deficit countries such as the US are in deep recession. The GFC also slowed growth in world trade, reducing China's surplus (which was running at 10 per cent of GDP in 2007 and is now less than 3 per cent).

The key issue, however, is whether these imbalances will re-emerge when growth gets back to normal, again threatening sustainability. To examine this, the IMF analysis adjusts for the cyclical position of each economy and compares this with what the Fund thinks the current account should be, given factors such as demography (aging populations might be expected to run surpluses) and stage of development (fast-growing emerging countries might be expected to run deficits). After these adjustments, China is still running a surplus around 3 per cent of GDP larger than the IMF thinks it should. The US is still running a deficit 2 per cent bigger than it should.

Intra-euro balances are the focus of special attention in the IMF report. The pre-2008 imbalance within the euro area is now described like this:

"Excessive compression of interest rate spreads across the union created unsustainable booms in the periphery as real interest rates fell, with the associated lending boom significantly financed by massive net flows from the core."

Germany's surplus is nearly 5 per cent of GDP bigger than is sustainable, while Spain should reduce its deficit to the same degree.

What policy adjustments are required? This being the IMF (often said to stand for 'It's Mainly Fiscal'), the first policy that needs changing is budgets: tighter in deficit countries and perhaps a bit looser in surplus countries. The deficit countries need to shift their budget deficits, on average, by 4 per cent of GDP. The Fund acknowledges that this might not be the best policy to adopt while economies are flat on their backs in recession, but the finger-wagging message is clear: at the earliest opportunity, budget profligacy must end.

This will not be enough, says the IMF. Structural improvements (productivity and 'product market flexibility'; code for more flexible labour markets) must come next. As these corrections take place, exchange rates will adjust further, with China appreciating by 5 to 10 per cent and the US depreciating by around 10 per cent. This correction sounds particularly dismal for Europe:

"An orderly adjustment process within the euro area is likely to be prolonged and costly for output given the absence of an exchange rate channel for adjustment."

Some Asian countries might be puzzled by the suggested adjustments. Indonesia, currently running a small current account deficit, is seen as needing the same exchange rate appreciation as Singapore, running a current account surplus equal to 20 per cent of its GDP. Singapore's current account imbalance is calculated to be smaller than Malaysia or Germany, because the IMF's 'norm' for Singapore is a continuing surplus equal to 20 per cent of GDP.

For China, the proposed structural improvement is to provide 'social protection' (health and pensions) which it is argued will lower household savings (in fact, China's saving is largely done by state corporations).

As usual, this analysis is the vehicle for an IMF morality tale. And as usual, the broad thrust of the tale is hard to dispute: budgets must be repaired, debt reduced and productivity enhanced. But again as usual, no one knows how to get onto the virtuous path. Even if they do, they prefer to put off the political pain until another day.

Other recent IMF analysis has evolved to acknowledge a role for policy in addressing the often-fickle and disruptive nature of international capital flows. The current paper is a relapse into the old mind-set. The Fund still has faith that if countries get their fundamental policies right, capital flows will be appropriate and exchange rates will find the right level.

As usual in fund documents, there is something for everyone. It is acknowledged that the GFC made capital flows to emerging countries volatile and potentially damaging to nascent financial markets (given the huge risk-on/risk-off surges and reversals since 2007, it would be hard to ignore this characteristic of capital flows). The fund also notes that capital is 'flowing uphill' from the fast-growing emerging economies to the mature economies. Yet the IMF sees only a minor supporting role for capital flow management and exchange rate intervention. The old mantra is repeated: 'restrictions should not be seen as a substitute for policy adjustment'.

It is surprising, then, that one seasoned observer sees this study as evidence that the Fund has belatedly adopted the approach advocated by John Williamson for the past couple of decades. Williamson's calculations of fundamental equilibrium exchange rate may be analogous to the Fund's current calculation of sustainable exchange rates. The Williamson approach, however, envisages that countries will use the full range of active policies (including intervention and capital controls) to keep their exchange rates inside a band around the FEER: the 'band-basket-crawl' approach. The fund still has more faith in the magic of the market than Williamson.

And what about Australia? The study sees the Australian dollar as overvalued by around 10 per cent and the sustainable current account deficit as around 3 per cent of GDP, about where we are at present.

Originally published by The Lowy Institute publication The Interpreter. Reproduced with permission.