The issues that are currently under discussion in G20 go much beyond the factors that triggered the global financial crisis. So long as the discussions were confined to issues relating to regulation and supervision, they flowed directly from the financial crisis. Quite clearly, what stands out glaringly in the recent crisis is regulatory failure in developed countries. The failure was of two kinds. First, not all segments of the financial system were adequately regulated or supervised. Second, there was imperfect understanding on the part of regulators on the nature and implications of the various complex derivative products. A new regulatory framework is being put in place. The philosophy of “light touch” is being given up. Besides tightening prudential regulations, there is a greater focus on the systemically important financial institutions. There is, therefore, a high degree of consensus on the elements that should form part of the new regulatory framework.
However, the discussions on issues such as global imbalances and development strategies take the debate well beyond the financial crisis. Many of these issues persisted long before the crisis erupted. Issues such as global imbalances are now coming in the way of a rapid global recovery. The G20 has, thus, emerged as a new forum for discussing global issues. With heads of states participating in the discussions, it has acquired a dominant position in shaping policies.
Global imbalances have persisted for more than a decade. While there are various kinds of imbalances in the world, it is the persistence of chronic deficits in the balance of payments in some countries and chronic surpluses in some others that has attracted the greatest attention. At one time, the current account deficit of the US was as high as 6 per cent of its gross domestic product (GDP). Chronic deficits imply the financing of these deficits continuously by chronically surplus countries. Any loss of faith in the currency of the deficit country, particularly when it also happens to be a reserve currency, has serious implications for the smooth functioning of the international monetary system. It is accepted by all that global imbalances need to be corrected. The US current account deficit has come down to 3.3 per cent of its GDP but it is feared that it may rise in the coming years. That is why an early action is called for to correct the imbalances. The recent G20 statement calls for indicative guidelines for timely identification of large imbalances. The level of current account deficit itself is an indicative measure of the imbalances.
Maintaining current account imbalances at sustainable levels should be part of the recovery process. In this effort, exchange rate adjustment is one important ingredient. In monetary history, there were several episodes when the international monetary system collapsed because appropriate exchange rate adjustments or monetary policy actions had not been taken particularly by the surplus countries. There is, therefore, a need for coordinated and symmetric actions among surplus and deficit countries.
It should, however, be recognised that the process of adjustment towards a more sustainable level of current account deficit by a rich country like the US has implications for other outward-oriented developing economies. Countries that are currently in balance or have a moderate deficit could find the deficits rising. The adjustment could be uneven for another reason as well. If the action of the US results in lowering the value of the dollar, but if China more or less pegs its currency to the dollar, then the burden of adjustment will be more on countries whose currencies have appreciated. Thus, if the dollar declines against the euro, the deficit of the European Union will rise. But the chronically surplus countries like China will continue to be in surplus. In short, the global imbalances may continue. All of this points once again to the need for coordinated action by G20 countries.
It is often argued that countries, particularly developing economies, must keep their currencies undervalued to promote trade and growth. Obviously, it is not possible for all countries to do this simultaneously. This will only result in competitive devaluation that will do no good to anyone. Though developing economies could undertake actions to prevent the impact of excessive capital inflows, by and large, the system must avoid a situation of competitive devaluation.
Though the exchange rate is an important element in correcting trade imbalances, a chronically deficit country like the US cannot expect to see a turnaround, unless it focuses on domestic factors. The chronic deficit in the balance of payments is reflective of the decline in its domestic savings rate and the widening gap between savings and investment. A great effort is needed to prop up the household savings rate.
Equally important is fiscal consolidation. The last few years have seen massive fiscal expansionism as an answer to the crisis. Though it is difficult to tighten fiscal policies at a time when the recovery is still weak, a medium-term strategy of fiscal consolidation is needed for countries like the US to come out of the imbalance trap.
As a way to come out of the current global imbalances, it has been proposed by the US to put a cap on current account deficit and surpluses of countries. The indicative number has been 4 per cent of GDP. Fixing a cap by itself does not solve the problem. What is needed is clarity on the actions that the countries can adopt, if they breach the cap. Can these actions be different from what they would have otherwise taken? Obviously, exceeding the cap by a deficit country cannot trigger the option to adopt protectionist policies. That would undermine the basis of international trade. Whether there is a cap or not, deficit and surplus countries must adopt policies that will lead to a more balanced growth of international trade. Indeed, all countries need to maintain an appropriate balance between domestic demand and external demand. Extreme dependence on external demand can pose problems, if growth of the world economy slows down. Each country must decide on the degree of openness with which it is comfortable.
A rebalancing of the world economy has become imperative. This needs coordination and cooperation among surplus and deficit countries. Neither side can have a stand-off attitude.
The writer is chairman, Economic Advisory Council to the Prime Minister
