Middle East/North Africa
Living with Gorillas
June 12, 2007

By Serhan Cevik | Doha

Financial globalization brings more benefits than challenges to emerging economies. Greater openness and closer integration throughout the world in the post-war period have brought tremendous benefits to all countries. However, these far-reaching gains come in waves over a long period of internalization and are not necessarily distributed equally, at least in the early stages, across the global economy. Just like productivity improvements from the proliferation of electricity in the 19th century and telecommunications in the 20th century, the full effect of synchronized business cycles and financial innovations may take decades to come through. Of course, in the interim period, all the countries face a variety of economic and financial imbalances created by structural changes in progress. Beyond social and political consequences, one of the pressing challenges is the issue of absorption, especially for emerging economies. Take, for example, the much-debated case of global liquidity. Whichever way you measure it, global liquidity has kept expanding at a rate much faster than asset creation. Consequently, the overwhelming cycle of liquidity-driven flows has pushed real interest rates lower across the world and fuelled economic activity well beyond the trend growth rate of the global economy. Even today, despite the US slowdown, the state of the world economy is much better than expectations just a few months ago and keeps risk appetite intact. However, although the benefits of globalization outweigh its challenges, abrupt, exaggerated adjustments are still a threat to financial stability.

Global economic fundamentals are strong, but a tightening of market liquidity is a risk. The global economy is going through a — very — gradual rebalancing phase, as the US economy underperforms relative to the rest of the world. There is of course a high degree of uncertainty about the dynamics of rebalancing in today’s world, and a possible deepening of consumer retrenchment in America would still have significant spillover effects. Therefore, as our chief economist Stephen Roach has long argued, the game is not over yet. Indeed, judging from the behavior of current account imbalances, there is little evidence of a meaningful correction at this stage. America’s current account deficit kept widening from 0.5% of global GDP in 1997 to 1.3% in 2000 and 1.8% last year, while the cumulative current account surplus of oil exporters and Asian countries (including Japan) surged from 0.5% of global GDP to 1.7% over the same period. Although there are some signs of adjustment, the process of global rebalancing is slow — mainly because of the complex nature of imbalances arising from structural changes as well as cyclical excesses (see Can the IMF Tame Gorillas?, October 3, 2006). However, the risk is not so much about economic fundamentals but stems from the self-reinforcing cycle of liquidity-driven flows, in our view. In the post-2001 period, starting with ultra-low interest rates, the recycling of current account surpluses has led to an extraordinary accumulation of ‘foreign’ assets around the world (see Pumping Money, May 22, 2007). As net foreign assets of oil exporters and Asian countries increased from 3.7% of global GDP in 1999 to 9.5% last year, we have witnessed the emergence of a new, liquidity-driven risk culture with lower home bias and greater appetite for ‘exotic’ markets and instruments.

Emerging economies stand on stronger footings, but capital flows still create excesses. You can spin anything anyway you like, but globalization has largely been a boon for the developing world. With prudent policies and structural reforms, emerging economies have maintained a rapid pace of growth and even become creditor to the rest of the world. However, having a current account surplus does not necessarily stop the inflow of foreign capital, which soared from US$50 billion a year in the 1980s to US$700 billion in 2006. Although financial globalization eases financing constraints on growth and brings dynamism to corporate sectors, the pool of global liquidity also comes with serious challenges, especially considering the funding structure of capital flows. For example, the outstanding notional amount of derivatives increased from US$5.7 trillion (or 26% of global GDP) in 1990 to US$415.2 trillion (or 789% of global GDP) last year (see Deriving Liquidity, June 4, 2007). These complex, structured instruments certainly help to distribute risk more broadly across financial systems, but have also become a major source of market liquidity for leveraged bets in search of higher returns in a world of low real interest rates. Of course, lacking adequate financial depth and sophistication, emerging economies remain vulnerable to excesses created by the overpowering cycle of capital flows.

Global rebalancing requires exchange rate as well structural adjustments. There are hints of rebalancing in the global economy, like America’s slowly narrowing current account deficit, China’s attempts to cool the pace of economic expansion, and even an increase in real interest rates. As a result, ‘excess’ liquidity — measured by money supply growth minus GDP growth in G5 countries and China — eased from an average of 4.3% between 2002 and 2005 to 0.5% at the end of last year. However, we believe that the explosive growth in derivatives has weakened the link between monetary aggregates and market liquidity. Therefore, the world economy still needs structural adjustments as well as proactive policy updates (like currency revaluation in Asia and oil-exporting countries) to stay on a sustainable growth path.

 

 

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