Global Stability And Imbalances (Stephen S. Roach)

  Stephen S. Roach -- Morgan Stanley Global Economic Forum 

  The IMF has just confirmed “the continued resilience of the global financial system.”  Does that mean that everything is fine and there is no need to worry? 

  With a record U.S. current account deficit still holding at 6.6 percent of U.S. GDP in mid-2006 and with the price differential between risky fixed-income assets (i.e., corporate credit and emerging market debt) and riskless assets (i.e., sovereign bonds) at historical lows, this is hardly a time for complacency.

  Overly accommodative central banks have pushed the global liquidity cycle to excess -- in effect, funding the resilience of the global financial system with cheap money.  With central banks now seeking to normalize monetary policies, that excess liquidity will get withdrawn -- posing a much more challenging climate for world financial markets and the global economy.  A turn in the global liquidity cycle is precisely the time when we should be worrying the most.

  Are market participants assessing the risks in financial markets adequately, or are they lulling themselves into a false sense of security?

  With the demographic clock ticking louder and louder at just the time when returns on traditional investments have declined, looming unfunded pension and retirement obligations have led to an extraordinary imbalance between assets and liabilities. Yield-hungry investors have, as a result, moved further and further out on the risk curve -- increasing their allocation to higher-yielding assets such as commodities, emerging markets, and what we have traditionally called “junk bonds.” In some segments of these traditionally riskier asset classes, the fundamentals have undoubtedly improved. But I am worried that yield-seeking investors have become indiscriminate in their appetite for yield and assessment of risk -- not differentiating the secure investments from the weak ones in riskier asset classes and, as a result, lulling themselves into a false sense of security.

  What are the biggest risks to global financial market stability?

  The growing drumbeat of protectionism is, by far, the biggest risk. Economic nationalism is on the rise in Europe, and China-bashing is in full swing in Washington. Since the beginning of 2005, the U.S. Congress has introduced 27 pieces of legislation that would impose trade sanctions of one sort or another on China.  The recent withdrawal of the so-called Schumer-Graham tariff threat to China does not defuse this broad bipartisan political threat. If any of the remaining 26 actions are enacted -- a serious possibility in a highly politically-charged climate that is rooted in the persistent near-stagnation of real wages -- China could well reduce its appetite for dollar-denominated securities. That, in turn, could pose an immediate and serious problem for the funding of America’s massive current account deficit -- an external imbalance that requires fully US$3.5 billion of capital inflows each business day of the year. Absent Chinese buying of U.S. securities, the dollar could plunge and real US interest rates might soar -- developments which could push the U.S. and global economies quickly into recession.

  The dangers of global imbalances have been stressed for many years.  Nothing has happened.  Aren’t these risks being exaggerated?

  The problem has been serious but the consequences have not been -- at least not so far. The world has bought time for two reasons: the excesses of the global liquidity cycle and the need for surplus savers to keep their currencies weak in order to maintain export competitiveness. As noted above, the world’s major central banks are now attempting to withdraw excess liquidity. At the same time, the world’s major surplus savers -- China, Japan, and Germany are hard at work attempting to stimulate internal demand. That would tend to absorb their excess saving -- leaving less foreign capital to send to saving-short America. By drawing comfort from the heretofore-benign consequences of a serious problem, global imbalances are ignored at great peril.

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