José De Gregorio: Adjustment in the global economy
Keynote address by Mr José De Gregorio, Governor of the Central Bank of Chile, at the 2011
Institute of International Finance (IIF) Latin American Economic Forum, Calgary, 27 March
2011.
* * *
I am grateful to Luis Oscar Herrera, Enrique Orellana and Tatiana Vargas for valuable comments.
Thank you very much for the invitation to speak at this 2011 IIF Latin American Economic
Forum. The last few years have been the most challenging for economic policy around the
world in many decades. From an unprecedented inflationary shock in 2007-08, the global
economy went through a financial crisis and a recession in 2008-09, of a scale not seen
since the Great Depression. Now, we are experiencing a process of recovery with strong
inflationary pressures and tensions in the world economy as a result of asymmetries in this
process. The purpose of my talk today will be the global adjustment, how it has been
proceeding and what the current challenges for policymaking are, with special focus on the
asymmetries and their implications for economic policy.
The uneven recovery
The world economy is growing unevenly and subject to many tensions. Most advanced
economies are recovering from the crisis, but they still have high rates of unemployment and
excess capacity, and this is expected to last for some time. Although there are signs of
improvements in the recovery, many economies are still in a weak financial position, and
domestic demand is expected to grow at low rates for some time. After years of financial
excesses, households in many countries, particularly in the U.S., have accumulated
excessive debt.
Many advanced economies also have weak fiscal positions, due to fiscal expansions
implemented to contain the recession, measures to support the banking sector, or simply the
fiscal profligacy that took place prior to the crisis. In particular, the level of government debt
in some European countries will require a significant and protracted fiscal consolidation to
avoid insolvency. Therefore, the deleveraging process of households and governments
implies that domestic demand is unlikely to be an engine of growth. As a consequence of this
scenario, the inflationary pressures will be relatively contained. The rise in commodity prices
is having effects on headline inflation, but the propagation to other prices will be limited
because of a negative output gap. This is in sharp contrast with the situation in emerging
market economies (EMEs). Accordingly, monetary policy in advanced economies will remain
expansionary, and despite some tightening in the near future, they will still have lower
interest rates than those in EMEs, and which will be well below what used to be considered a
neutral stance.
In contrast, EMEs have been growing strongly, and after suffering moderately from the global
crisis, many have already reached levels of full capacity, and some of them may even be
overheating (Figure 1). At a global level, the buoyancy of EMEs has resulted in higher
commodity prices, which coupled with some specific factors, such as weather problems
impacting agricultural production and tensions in the Middle East and North Africa, have
pushed food prices to record highs and oil prices to very high levels as well. This price shock,
coupled with strong domestic activity, results in inflationary pressures that must be contained
with tighter monetary policy. Contrary to the situation in advanced economies, international
price (supply) shocks find fertile territory to propagate to wages or other prices when the
economy is in a strong cyclical position.
This uneven recovery of the world economy is resulting in an uneven monetary policy
landscape (Figure 2), which strengthens currencies in EMEs and induces capital inflows to
these countries. Free trade and export-led growth have been a successful growth strategy in
developing countries, which see the strengthening of their currencies as a threat to this
strategy. Consequently, many countries have been trying to fight the appreciation via capital
controls and exchange rate intervention.
China and the U.S. deserve special mention, as they are at the center of the tensions of the
adjustment. China has been the growth engine of the world, and it would not be an
exaggeration to call it the "grower of last resort" for the global economy. They have decided
to appreciate gradually, much more slowly than most EMEs and commodity exporters. Since
December 2009, the yuan has appreciated almost four percent, while this figure is much
closer to ten percent for most EMEs. The comparison is even more dramatic when looking at
a longer period of time. This has been achieved through massive reserve accumulation and
limited financial integration. However, for measures in the foreign exchange market to have
real effects - that is, on the real exchange rate, which is the relevant variable from the point
of view of competitiveness - these measures need to have some support from the real side
of the economy. In the case of China, this is a very high savings rate. China saves about half
of its GDP and the resulting current account surplus sustains a depreciated real exchange
rate. Otherwise, attempts to maintain a depreciated nominal exchange rate sooner or later
lead to inflation, which is the way to achieve relative price adjustment when the nominal
exchange rate is not allowed to adjust.
The U.S., in turn, is undertaking an extraordinary monetary expansion. Beyond having
reached the zero lower bound for the federal funds rate, unconventional measures are
adding additional monetary stimulus. In particular, the massive purchase of securities
implemented in the so-called QE2 program. This explains why the dollar has reached its
lowest level in several decades (Figure 3), but this is not only the result of expansionary
monetary policy, but also of the lack of domestic demand and of the external imbalances.
Global rebalancing of the world economy needs countries in a strong cyclical position to
direct domestic demand to imports, while countries with insufficient domestic demand to
increase exports. Exchange rate adjustment should facilitate this process. Therefore, a faster
appreciation of the yuan would relieve some appreciatory pressures in other EMEs, making
the adjustment more balanced. But, for this to be achieved on a sustained basis, it is not
enough to let the exchange rate adjust. Structural reforms will also be required to achieve a
sustainable and efficient reduction of China's savings rate. On the other hand, a rise in
advanced economies' interest rates, in particular in the U.S., would also alleviate currency
tensions. However, the main responsibility for policymakers is to secure sustainable growth
in their home economies that favors their citizens, and we all have to deal with the
repercussions of those actions.
The response in emerging market economies
Emerging market economies have been facing two challenges as a consequence of this
global environment. First, exchange rate appreciation and a resumption of capital inflows,
and second, inflationary pressures. Sometimes, these two challenges may lead to
inconsistencies in macroeconomic management. However, it is important to highlight that in
small open economies any attempt to persistently manage an exchange rate away from its
fundamentals, in particular at an overvalued level, may end up leading to inflation. If the
adjustment does not come from a change in the value of the currency, it will happen through
inflation. This is the reason why it is an illusion to think that central banks can control both the
exchange rate and the inflation rate. However, there are options available to transitorily
reduce pressure on the exchange rate while monetary policy continues to focus on price
stability.
In a flexible inflation targeting framework, a first implication regarding exchange rate
fluctuations is that monetary policy would tend to lean against the wind. Indeed, a persistent
exchange rate appreciation would have disinflationary effects and would induce a looser
monetary policy than the one that would prevail with a more depreciated exchange rate
(everything else constant). However, in the current juncture, this effect does not prevent the
need to tighten monetary policy, given strong growth in EMEs and inflationary pressures
coming from commodity prices.
A second option to mitigate currency appreciation is exchange rate intervention. In order to
keep control on the interest rate, this intervention must be sterilized. Of course it has lower
effects than when the monetary impact is not sterilized, but it is consistent with inflation
stabilization. In Chile, since 2008 we have intervened twice, and we have implemented it in a
pre-announced way, with a known schedule for intervention and sterilization, so it does not
interfere with monetary policymaking. The rationale for the intervention was twofold. On the
one hand, to accumulate reserves, strengthening our international liquidity position, and on
the other hand, to provide some transitory relief to sectors that need to undergo an
adjustment due to current international conditions.
A more debated tool is the use of capital controls. This is particularly important for countries
that are going through a period of important net capital inflows, which is not the case of Chile.
Capital controls are part of the central bank's toolkit in EMEs. However, their effectiveness is
still a matter of discussion, and instead of discussing this evidence I would like to point to
distortions that they may bring about. First, they may redirect capital inflows from controlled
segments of the financial system to uncontrolled ones, fostering the shadow banking system.
And second, they may generate discriminations in the corporate sector as some firms may
have access to foreign financing free of controls, while other firms, especially small and
medium sized enterprises, have to seek financing from more expensive domestic sources.
Capital controls are not only a macro tool, but have recently been considered
"macroprudential" measures as well. Their purpose is to avoid the building up of financial
vulnerabilities, in particular currency and maturity mismatches. But, this can also be achieved
with regulation directly introduced to prevent these mismatches and through appropriate risk
management. Finally, given some recent calls for the use of capital controls in EMEs, there is
a collective action problem. As one country imposes capital controls, it pushes international
financial flows elsewhere, inducing others to impose capital controls, and so on. Now
assume that all countries are able to impose capital controls so that at the margin, there are
no changes in net capital flows. Then the global adjustment would not take place, EMEs
would grow beyond their potential, generating inflation, while weak economies would be
trapped with low demand growth. EMEs can still try to temper capital inflows transitorily, but
to completely avoid them would be unfeasible and inefficient.
Concluding remarks
Despite all the current tensions, the global economy is adjusting. Exchange rates of EMEs
and commodity exporters have been strengthening - albeit at different speeds as some
economies try to smooth the adjustment - and the global recovery is taking place (Figure 4).
Fortunately, trade restrictions, which represent the biggest threat to the global recovery, have
not been implemented.
In recent weeks we have witnessed increased tensions in the world, such as the turmoil in
the Middle East and North Africa and the natural and nuclear disasters in Japan. We need to
play close attention to these developments, but they should not change the perspectives of
the dual-speed recovery in the world economy.
As discussed above, the policy decisions in large countries have repercussions on the rest of
the world. However, the main role for policymakers is to secure recovery and to create the
basis for sustainable growth, which requires macroeconomic and financial stability. Policy
measures in the U.S., such as QE2, are trying to do just that. Beyond our professional
assessment, a successful recovery in the U.S. is good for the world economy. By the same
token, Chinese authorities have decided on a gradual path of adjustment to secure enough
growth for all the social and economic needs they face. From a macroeconomic standpoint,
their policy of exchange rate management is something many EMEs have tried several
times, and although I am a firm believer that exchange rate flexibility is crucial for small open
economies, it is of course not the general rule and is not be to be applied in all cases and
under all circumstances, especially for large low-income economies. Overall, the world needs
a sustained recovery in the U.S. and growth in China.
The same is valid for EMEs. We need to contribute to the global adjustment, but our main
concern must be the welfare of our citizens. Containing the current inflationary pressures is
essential to allow for sustainable growth. Delaying monetary policy adjustment may result in
more severe adjustments in the future. Also, rebuilding fiscal buffers is important in order to
have a more balanced recovery and to be better prepared to conduct macroeconomic
policies. Some days ago, the Chilean government announced a timely and relevant fiscal
tightening that should contribute to the moderation of aggregate demand.
The world is not going through a currency war; neither are EMEs being flooded by liquidity
from advanced economies. But, in EMEs, there are many tensions and challenges that we
must deal with appropriately in order to build more resilient economies and take full
advantage of the great progress achieved during recent years in terms of macroeconomic
and financial stability. These are the main contributions central banks can make to their
countries.
Figure 1
World output (1) Output gap (3)
(annualized quarterly change, percent)
15 15 4 4
10 10 2 2
5 5 0 0
-2 -2
0 0
-5 -5 -4 -4
-10 -10 -6 -6
05 06 07 08 09 10 00 02 04 06 08 10
Developed economies
Emerging economies (2)
Emerging Asia
Developed economies
Latin America
(1) PPP-weighted regions. (2) The fourth quarter is an estimate. (3) Gap obtained with the HP filter,
except in advanced economies, where OECD estimates were used.
Sources: Central Bank of Chile based on data from Bloomberg, Consensus Forecasts, OECD, and the
statistics offices of each country.
Figure 2
Monetary policy rates around the world (1)
(percent)
9 9
8 8
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0
06 07 08 09 10 11
Chile Developed econ. (2) Emerging eco. (3)
(1) Corresponds to a simple average of the reference rates for each group of countries. (2) Includes
Euro area, Japan, United Kingdom, and United States. (3) Includes Brazil, Czech Republic, China,
Colombia, Hungary, South Korea, Mexico, Peru, Poland, and South Africa.
Sources: Central Bank of Chile and Bloomberg.
Figure 3
U.S multilateral nominal exchange rate (*)
(index, March 1973=100)
160 160
140 140
120 120
100 100
80 80
60 60
73 79 85 91 97 03 09
(*) An increase indicates a depreciation of the dollar against main trading partners.
Figure 4
Real exchange rate (1)
(index; 2005=100)
120 120
110 110
100 100
90 90
80 80
70 70
06 07 08 09 10 11
Latin America (2) Emerging Asia (3)
Emerging Europe (4) Commodity exporters (5)
United States
(1) Correspond a simple average of the real exchange rate for each group of countries. An increase
indicates depreciation. (2) Includes Argentina, Brazil, Chile and Mexico. (3) Includes China, Hong
Kong, Indonesia, Malaysia,South Korea, and Thailand. (4) Includes Hungary, Poland, Czech Republic,
and Russia. (5) Includes Australia, Canada and New Zealand.
Source: BIS.