Global imbalances and financial reform with examples from China.

• Author: Rajan, Raghuram G.

I will focus on a familiar issue, the problem of global current account imbalances, and will describe how financial sector reform can help narrow them, using examples from China.

The United States is running a current account deficit approaching 6.25 percent of its GDP and over 1.5 percent of world GDP. To help finance it, the United States pulls in 70 percent of all global capital flows. Clearly, such a large deficit is unsustainable in the long run.

The current situation has its roots in a series of crises over the last decade that were caused by excessive investment, such as the Japanese asset bubble, the crises in emerging markets in Asia and Latin America, and most recently, the IT bubble. Investment has fallen off sharply since, with only very cautious recovery. This is particularly true of emerging Asia and Japan. The policy response to the slowdown in investment has differed across countries. In the industrial countries, accommodative policies such as expansionary budgets and low interest rates have led to consumption- or credit-fueled growth, particularly in Anglo-Saxon countries. Government savings have fallen, especially in the United States and Japan, and household savings have virtually disappeared in some countries with housing booms.

By contrast, the crises were a wake-up call in a number of emerging market countries. Historically lax policies have been tightened, with some countries running primary fiscal surpluses for the first time, and most bringing down inflation through tight monetary policy. With corporations cautious, and governments abandoning the grandiose projects of the past, investment has fallen off. Instead, exports have led growth. Many emerging markets have run current account surpluses for the first time. In emerging Asia, a corollary has been a buildup of international reserves.

Two Kinds of Transition

The world now needs two kinds of transitions. First, consumption has to give way smoothly to investment, as past excess capacity is worked off and as expansionary policies in industrial countries return to normal. Second, to reduce the current account imbalances that have built up, demand has to shift from countries running deficits to countries running surpluses.

There are reasons to worry whether the needed transitions will take place smoothly. Perhaps the central concern has to be about consumption growth in the United States, which has been holding up the world economy. I will not dwell on the obvious risks to it, which include energy prices, stretched housing prices, and inflation. My greatest worry is not that U.S. consumption growth will slow--it has to because it is being fueled by unsustainable forces. My worry is that it will slow abruptly, taking away a major support from world growth before other supports are in place.

One of those other supports is more investment, especially in low-income countries, emerging markets, and oil producers. Parenthetically, China is an exception in needing less, not more, investment. The easy way to get more investment is a low-quality investment binge led by the government or fueled by easy credit--emerging market countries are only too aware of the pitfall of that approach. The harder, and correct, way is through structural reforms that would improve the business environment, increase labor market flexibility, raise expected rates of return, and improve the allocation and utilization of capital by the financial and corporate sectors, all of which would promote more high-quality investment. Somewhat paradoxically, though, the favorable global economic environment and the resulting ability of many countries to rely on exports for growth have allowed their governments...