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Economics Weekly

Will the credit crunch help ease global imbalances?

Mon, Apr 14 2008, 12:11 GMT
by Trevor Williams

Lloyds TSB Financial Markets

Credit crunch forces IMF to revise down growth forecasts…
Without a doubt, the credit crisis has the potential to really set global growth back quite substantially. In its latest Global Financial Stability Report, the IMF sets out how this could happen. And in the latest IMF World Economic Outlook, its revised growth estimates detail the impact the credit crunch will have on the world economy. The IMF has lowered its global growth forecast by ½% to 3.7% for 2008 but the biggest effect will be on the U.S. The IMF cut its forecast for US growth in 2008 to just 0.5% from 1.5%; for the UK to 1.6% from 1.8% and the euro area to 1.4% from 1.6% previously.

Interestingly, these changes leave the UK as the fastest growing out of this group. However, the main issue is that the IMF is now more pessimistic about global growth as a result of the severity of the credit crisis than it was in the last report in December 2007. But it is also true that its forecast for the emerging market economies shows a downward revision to economic growth of just 0.2%, to 6.7% in 2008. So this means that its 1 percentage point reduction in US growth for this year has barely impacted the growth of the developing economies. This is a big change from the past, but that is not our main focus in this note.

...but a silver lining could be that slower US growth will help to reduce global imbalances that in time would have resulted in a more severe crisis
Our main focus is on the fact that the effect of the credit crisis, in forcing the US to grow more slowly (and others to adjust to that) and in reducing its trade and current account deficit, is effectively raising the US savings rate. This could be one of the few bits of good news that comes out of the credit crisis, because it helps to reduce one of the key global imbalances that the IMF has warned in the past had the potential to derail the world economy. Indeed, such a correction might have had an even greater impact on the global economy than the credit crisis appears to be exerting, because it might have hit the emerging economies harder.

US and UK have been saving too little, consuming too much…
What do we mean? Effectively, the US has been consuming too much or saving too little for about a decade. This is shown in chart a, where the current account deficits of the US, UK, EU and Japan are compared in terms of their percentage of economic output, or gdp. The point is clear: the US, and in fact the UK also, have been seeing a drift further into deficit, with Japan increasingly in surplus and the eurozone economy’s external trade in balance. This implies that the UK and the US have been consuming more goods than their trading partners, in other words saving too little. Of course, it also suggests that Japan as a whole has been saving too much. The implications of this for exchange rates in trade weighted terms are very clear; the dollar has been falling and the yen has been rising, the euro is at around its fair value and sterling is currently falling, see chart b. These shifts are in line with what economic theory would suggest, see charts c and d. Growth in the countries with the large external deficits needs to slow relative to those economies in surplus and or the exchange rates of the deficit countries must fall. The more extreme the imbalance, the more extreme will be the movement in the exchange rates of the economies concerned.

…but fall in the $ & £ and slower growth is helping to restore balance
Our analysis shows that the US trade weighted index is the lowest it has been on record and that the UK’s trade weighted index has fallen by 12% since the peak in 2007. The fall in the US trade weighted index seems to be narrowing its external imbalance and so reducing its share of gdp, though there is a long way to go to achieve balance (the deficit is still over 5% of gdp) so the currency may remain weaker than it otherwise would for some time. Unfortunately, the level of the UK’s external deficit relative to the size of the economy has grown and suggests sterling could fall even further before stabilising.

…this may be the only silver lining in the credit crisis
Hence, insofar as the credit crisis ensures that the UK and US economies’ growth rate will slow, the inevitable correction in external imbalances that would have occurred at some point in the future seems to be happening now. This is possibly one silver lining in the severe negative impact that the credit crisis is having on the developed economies. It appears not to be affecting the emerging much at this time. By occurring now, at a time that the emerging market economies are growing faster than the global average and the developed countries, see chart e, the potential for the US and the UK to export their way out of difficulty is much improved. But this does assume control of price inflation risks implied by the sharp fall in the value of the US$ and UK£. In other words, the US and UK authorities must accept slower, but more balanced growth (away from consumption and towards manufacturing and exports), rather than higher inflation that would stem from efforts to maintain consumer spending through too low interest rates.

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Published on  Mon, Apr 14 2008, 12:20 GMT

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