Y V Reddy: Global imbalances - an Indian perspective
Keynote address by Dr Y V Reddy, Governor of the Reserve Bank of India, at the Financing for
Development (FFD) Office, Department of Economic and Social Office (DESA), United Nations, New
York, 11 May 2006.
* * *
Honourable Under Secretary General, Mr. Ocampo, Ambassador Nirupam Sen and Distinguished
Guests,
It is a privilege and an honor to be invited at the United Nations to deliver a talk on 'Global Imbalances:
an Indian Perspective". I would like to thank Professor Jose Antonio Ocampo, Under Secretary
General, for inviting me to deliver this talk. In my presentation today, I hope to capture the debate
among the policy makers as well as academics; though I must be humble in the presence of Mr.
Ocampo who has been a Minister, and a Professor and currently international civil servant of
eminence. To benefit from the discussions that are expected to follow, I will restrict my presentation to
about 30 to 40 minutes.
First, I would like to reflect upon the international perspective on global imbalances by raising three
issues: (a) the essential features of the global imbalances as they stand today, (b) possible causes of
these imbalances, and (c) the emerging consensus on policy responses.
Second, I will attempt to highlight India's perspective on the global imbalances. While doing so, I would
try to cover the following aspects: (a) India's role in global imbalances, (b) approach to global
consensus on causes and policy responses, (c) possible impact of global imbalances on India, and (d)
the emergence of oil as a new factor in the policy debate on global imbalances.
Third, I shall explore a possible agenda for analysis to enable better understanding of global
imbalances.
I. Global perspective on global imbalances
(a) Essential feature of the global imbalances
It is useful to understand that in different countries the existence of a current account surplus or deficit
is inevitable among economies at any given time. In particular, one of the arguments in favor of global
integration is that capital may flow from developed economies to the capital starved developing
economies which implies that there would be current account deficits in the latter. The problem is not
the existence of current account deficits or surpluses per se, but it is persistence of large current
account deficit and large current account surplus, particularly in large and systemically important
economies, which give rise to fears of unsustainabilty and disruptive unwinding.
(b) Possible causes of global imbalances
The current global imbalance is reflected in large mismatches in the current account positions in some
countries and its mirror image in the form of domestic saving-investment mismatches. For instance,
the US current account deficit was 6.4 per cent of GDP in 2005 and stood at US $805 billion. While the
current account surplus of Japan and emerging Asia accounted for about 60 per cent of the current
account deficit of the US. Now, with rising oil prices, the oil exporting countries also exhibit large
current account surpluses.
It is argued by some that since the late 1990s, the growth processes in many emerging market
economies (EMEs), especially those from Asia, have come to rely heavily on external demand. Under
such a scenario, it has been felt, many of these countries tried to maintain their external price
competitiveness by keeping their currencies undervalued. The process, it is stated, in turn, led to large
trade and current account surplus for the Asian EMEs and large trade and current deficits elsewhere in
the world, most noticeably in the US.
It is also clear that the sharp deterioration in the saving-investment balance in the US in the recent
years along with sustained rise in consumption demand, could only be met by rising imports; hence
rising large current account deficits in the US. The adverse shift in saving-investment balance in the
US is reflected both in the high budget deficit since 2002 and the deterioration in net personal saving
since 1998.
(c) The emerging consensus on policy responses
The global imbalance as it stands today may get corrected on its own and perhaps there could be
chances of a less favorable outcome of disorderly correction. It is held that one scenario could be that
an orderly private sector led adjustment in imbalances could materialize even without policy action. It
is argued that, however slim the chances of a disorderly adjustment, in view of huge cost of disorderly
adjustments, public policy cannot afford but strive for relatively orderly adjustment. In any case, it is felt
that there is a need for better understanding of policy issues with a view to take appropriate policy
actions as also to minimize the cost of adjustments if it were to take place in not very orderly fashion.
We have viewed, like many others here, that the sustained and increasing imbalances in the current
account positions across the globe could entail serious risks for the functioning of the international
monetary system. Rebalancing is best seen as a process with many moving parts that involve all the
major actors in the global economy. The successful execution of rebalancing will require a careful
application of traditional macro policies - monetary, fiscal, and currency policies - as well as
implementation of comprehensive micro agenda of structural reforms.
A significant part of the debate seems to be on relative weights to be accorded by each country to the
various elements of the package and the aspects of coordination among the countries that are
appropriate. As regards the current global initiatives to correct global imbalances, the Communiqué
issued by the International Monetary and Financial Committee (IMFC) released on April 22, 2006
highlights that action for orderly medium-term resolution of global imbalances is a shared
responsibility, and will bring greater benefit to members and the international community than actions
taken individually by countries. Key elements of the strategy towards orderly resolution of the global
imbalance suggested in the Communiqué are as follows:
•
Raising national saving in the United States - with measures to reduce the budget deficit and
spur private saving;
•
Implementing structural reforms to sustain growth potential and boost domestic demand in
the euro area and several other countries;
•
Further structural reforms, including fiscal consolidation, in Japan;
•
Allowing greater exchange rate flexibility in a number of surplus countries in emerging Asia;
and,
• Promoting efficient absorption of higher oil revenues in oil-exporting countries with strong
macroeconomic policies.
In the light of the above, the adjustments that are generally advocated in the individual economies and
regions may be summarized as follows:
i. A major challenge for US authorities could be to seek policies that balance between measures
to boost personal saving coupled with measures to cut consumption. However, US policies
would need to delicately balance a gradual withdrawal of fiscal stimulus without hurting the
recovery. It should be noted that demand compression could result in another recession, which
would not be in the interest of the global economy. A gradual realignment of the real exchange
rate of the US dollar coupled with measures targeted towards fiscal consolidation is generally
advocated. Having said that, proper calibration would hold the key to the success of such a
policy mix and this is an important public policy issue.
ii. The Euro area, which continues to depend largely on external demand, could pursue some
structural reforms, especially product and labor market policies, to boost domestic demand and
broad-base the recovery. While there are signs of recovery in investment, it is recognized by
many that further progress would be helpful to foster better integration of labor, health care,
product, pension and financial market reforms. It is recognized that structural reforms by their
nature are complex and their impact at best could be only over the medium term.
iii. We are already witnessing that the Japanese economy is on the way to recovery; the current
account surplus has begun to narrow against the background of strengthening domestic
demand, which is critical. Thus, the Japanese economy is expected to continue to take some
concrete measures to strengthen its financial system, restructure the corporate sector, and
reduce large fiscal imbalances.
iv. As for the emerging economies, especially in Asia, some experts suggest that the growth
strategy could be reoriented towards domestic demand to offset possible declines in exports to
the US. There are already some signs of strengthening in domestic demand in this region. It is
felt that improvement in the investment climate to support higher private investment in the
emerging economies is important. It is argued by some that the exchange rate policy may
require some attention of the policy makers in the region. However, some others consider that
exchange rate adjustments may not serve the interests of output and employment in these
countries, while effectiveness of such exchange rate adjustments by themselves in unwinding
the imbalances is not conclusive.
v. The oil exporting countries have recorded large trade surpluses, the investment of which in the
domestic market and abroad would help rebalancing global demand. It is suggested that these
countries could boost expenditures to some extent in areas where social returns are high like
education, health, infrastructure and social security. It is felt that structural policies to strengthen
legal and economic infrastructure in these countries may help promoting investment. However, it
is also argued that in many oil exporting countries scope for domestic absorption is limited in the
short run.
II. India's perspective on global imbalances
(a) India's role in global imbalances
Since Independence, India has moved from a moderate growth path of the first three decades (1950
to 1980) to a higher growth trajectory since the 1980s. Over the last two and a half decades, India has
emerged as one of the fastest growing economies of the world, averaging about 6 per cent growth rate
per annum and the ranking of the country in terms of size of the economy, especially in purchasing
power parity (PPP) terms, has improved. In the last three years, we have averaged a growth rate of 8
per cent. Apart from registering impressive growth rate over the last two and a half decades, India's
growth process has been stable. Studies indicate that the yearly variation in growth in India has been
one of the lowest. During this period, we have faced only one crisis in 1991. The crisis was followed by
a credible macroeconomic structural and stabilization programme encompassing trade, industry,
foreign investment, exchange rate, public finance and the financial sector. The Indian economy in later
years, could successfully avoid any adverse contagion impact of shocks from the East Asian crisis, the
Russian crisis during 1997-98, sanction like situation in post-Pokhran scenario, and border conflict
during May-June 1999.
In this context, it is appropriate to view the evidence that the policies followed by India have not in any
way contributed to the widening of the current global imbalances:
(i) Between 2001-02 and 2003-04, India registered modest current account surpluses, but this
was more of a reflection of phase of business cycle, and with the turn around in the business
cycle, India has registered a modest current account deficit in the last two years. In fact,
going by the current indication and the projections of the tenth Five Year Plan, India is likely
to maintain a modest and sustainable current account deficit in the near future.
(ii) It is observed that generally current account surplus accounted for a considerable proportion
of reserve accumulation in most of the Asian EMEs and Japan during 2000-05. For India,
current account surplus has been a minor source of reserve accretion. In our case, capital
flows, as opposed to current account surpluses, played an increasingly important role in the
accumulation of reserves.
(iii) Our approach aimed at market determined exchange rate with no predetermined target
along with market interventions essentially to manage volatility has served us well. At the
empirical level, the flexibility of Indian exchange rate policy is captured by marked two-way
movement of Indian rupee against the major currencies including US dollar. Recent
international research on viable exchange rate strategies in emerging markets has lent
considerable support to the exchange rate policy followed by India.
(iv) The main driver of growth in India has been domestic demand. Impressive growth in exports
and imports does strengthen the economy but the ratio of exports to GDP in India is lower
than most EMEs.
(v) The overall improvement in GDP growth during the reform period has also been facilitated by
improvement in the rate of aggregate domestic saving. For instance, in the high growth
phase of last three years, the saving rate rose by 5.5 percentage points from 23.5 per cent in
2001-02 to 29.1 per cent in 2004-05. Gross domestic investment rate, for the first time,
remained above 30 per cent in 2004-05, mainly on account of private investment growing at
19.7 per cent. With the Fiscal Responsibility and Budget Management Act in place, the fiscal
situation in India has shown improvement in the recent years. The fiscal consolidation
process envisages phased reduction in the key deficit indicators. Monetary policy, while
being supportive of investment demand places emphasis on price and financial stability and
has succeeded in containing inflation expectations. These factors give confidence to the
possibility of sustaining the present growth momentum - GDP growth of close to 8 per cent
per annum.
India has, thus, been following policies which not only served it well but also contributed to global
stability. As mentioned by our Finance Minister, Mr. P. Chidambaram, we do not expect any change in
the basic framework of our policies both in terms of growth based on efficient use of capital and
stability assured by sound macroeconomic policies.
(b) Approach to global consensus on causes and policy responses
We view that global developments, particularly those in the world financial markets, have the most
direct and serious impact on the financing conditions in the emerging markets. Any abrupt and
disorderly adjustment to global imbalances may have serious adverse implications. Recognising these
developments, Prime Minister of India, Dr. Manmohan Singh in his welcome address to the Board of
Governors of the Asian Development Bank (ADB) at the 39th Annual General Meeting in Hyderabad, a
couple of weeks ago, highlighted the importance of correcting these imbalances. I quote from his
address:
"While to some extent mismatches in current account positions are to be expected - and
even desirable - in the global economy, large disparities raise concerns about
unsustainability and hard landings. The process of correcting imbalances can be disruptive if
it is sudden and unexpected. The present level of global imbalance cannot be sustained
forever. It calls for action both from countries having current account surpluses and those
having current account deficits. A coordinated effort is necessary to correct the imbalances
to prevent a sudden down turn. International financial institutions need to play a proactive
role in this regard".
During the same Annual Meeting of the ADB in Hyderabad our Finance Minister Mr. P. Chidambaram
while dwelling at length on the issue of global imbalances highlighted that we have to address the
global imbalance in such a manner so that the benefits of global integration continue in an
uninterrupted fashion. He pointed out that Asia has an important role to play in conjunction with other
countries in the process of unwinding of global imbalance. I quote from his address:
"I must reiterate that to sustain the recovery process and to correct the global imbalances in
an orderly manner, there is an imperative need for a cooperative approach."
We had raised the issue of global imbalances in the Reserve Bank of India's Annual Report of the
2002-03 realizing at that time that this problem has the potential to occupy the attention of the global
economies in future. The Report observed:
"Although growing imbalances may seem to be an integral feature of globalization, there are
nonetheless limits to the accumulation of net claims against an economy that are implied by
persistent current account deficits. The cost of servicing such claims adds to the current
account deficit and, under certain circumstances, can be destabilizing"
The apprehensions expressed, in retrospect, proved to be warranted.
At this juncture, it is appropriate to list some important considerations that should govern initiatives in
regard to resolution of global imbalances recognizing that such policy initiatives may be broadly in
consonance with emerging consensus described earlier in the address.
First, it is necessary for multilateral institutions like IMF to be seen as symmetrical in their analysis of
national economies and their relative positions in the global economy. This would add credibility to the
policy advice that could be considered by each country.
Second, at the same time, action by each country will be governed by enlightened national interest. It
is necessary for multilateral institutions to analyze, explore and convince how the policy actions would
serve the long term national interest.
Third, it is desirable to convince the policy makers in each country that actions considered appropriate
are in the long term interest of the country itself. In this regard, the contextual challenges for each
economy should be given due weight. For example, in countries like India, employment and poverty
reduction need to be given highest priority.
Fourth, it is essential to recognize that co-ordination is necessary given the complex situation where
neither the causes nor the solutions are clear-cut. As a first step, there could, however, be a broad
agreement on the directions and the first principles that are most appropriate. Emphasis on harmony
in policies and search for co-operative solutions appears appropriate.
(c) Possible impact of global imbalances on India
As highlighted by our Finance Minister during the recent ADB annual meetings that apart from the
impact on the real and external sectors, it is felt that the developments in the currency and capital
market are intrinsically intertwined with the global imbalance and, therefore, in the eventuality of a
disorderly correction, disruption in these markets in the form of large cross-currency volatility and
sharp rise in interest rates are likely in the global economy. What could be the possible impact of less
than orderly adjustment of global imbalances on the Indian economy?
India does not depend on the international capital market for financing the fiscal deficit and
consequently to some extent adverse consequences of the global developments would be muted.
However, there could be a spill-over effect of global developments on domestic interest rates and thus
on fisc also. The fiscal position of the Government could also be indirectly impacted through the nature
of management of foreign exchange reserves held by the Reserve Bank.
Similarly, any abrupt adjustment in global imbalances may affect corporates, banks and households in
India though the impact may be less than some other emerging economies.
With respect to the impact on corporates, if there is widening of spreads due to a shift in investor
confidence in the international markets, those corporates which have borrowed at variable rates may
possibly suffer more than those, which have taken loans on a fixed rate basis. Corporates which have
hedged against currency and interest rate risks may escape the adverse effects. It may be noted that
the Reserve Bank has been urging banks to encourage corporates to hedge their foreign currency
exposures. Further, exposure of the corporate sector as a whole to the external debt is limited by
indicative ceilings on external commercial borrowings imposed by the Government and the Reserve
Bank of India. The level of total external debt of India is currently less than the foreign exchange
reserves.
Although banks in India have their deposit base predominately in rupees and their investment in
foreign currency assets is not large, they have been financing investment in assets, home loans and
the retail market as well as equities. Like in many EMEs, asset prices have risen sharply in India too.
Should there be a reversal of capital flows, asset prices may decline but the banks exposure to the
risky assets have been severely restricted by Reserve Bank's regulatory actions. Likewise, the equity
market has also seen a sustained uptrend but efforts have been made by the Reserve Bank to cap the
banks' exposures. Further, banks in India have invested significantly in government debt and other
fixed income securities. If a rise in international rates gets reflected in domestic interest rates, banks
will have to mark down the value of their investment portfolio. To the extent a rise in international
interest rates impacts the domestic interest rates, it would entail marked-to-market losses on the
investment portfolios. However, the banking sector has acquired some added strength to absorb such
probable shocks, largely aided by regulatory actions.
As regards impact on the households, there is a risk that rises in interest rates in general could impact
the housing market and expose the balance sheet of the households to interest rate risk, increasing
the risk of loan losses for banks. The overall banking sector's exposure to housing loans being
relatively small, adverse developments may not have any systemic implications on the banking sector.
(d) The emergence of oil as a new factor
The emergence of large current account surpluses among the oil exporting countries is an important
recent development. The current account surplus of the oil exporting countries increased from 6.2 per
cent of their GDP in 2001 to 19.1 per cent in 2005. Less than third of the combined current account
surplus of the oil exporting countries has been reflected in their foreign exchange reserves which rose
by US $ 90 billion in 2005. The IMF (World Economic Outlook, April 2006) has highlighted that to the
extent that higher net savings by oil exporters have driven down global interest rates, and that these
lower rates have boosted demand in economies with market based financial systems, such as the
United States, the oil price shock may also have had an additional negative effect on the US external
position.
The fact remains that the rising oil prices would result in further widening of global current account
imbalances as according to consensus forecast the current account balance of the US is projected to
deteriorate further in 2006. Other industrialized economies are projected to run a combined surplus led
mainly by Japan and Germany. The aggregate current account surplus of the major oil exporting
countries is expected to increase further in the near term.
In this regard, it may be noted that India's oil import bill amounted to 2.9 per cent of GDP in 2001-02,
but the bill climbed to 5.5 per cent of GDP in 2005-06, though in volume terms the increase has been
marginal.
III. Agenda for analysis
In view of complex nature of global imbalances and the way forward to minimize the risks of disorderly
adjustments, it may be useful to explore possible agenda for further analysis.
First, national balance sheets, as mentioned by Governor Mervyn King, could be given special
attention to get a fuller picture of financial claims that countries have against other countries. Looking
at the national balance sheets would also be useful to acquire a sense about the potential for
adjustment, and they will give a sense of the possible impact of relative price changes on the value of
assets and liabilities. The composition and size of the liabilities and assets of the national balance
sheets are crucial as by viewing them together we could get a global picture. However, we should look
deeper into the balance sheets in terms of disaggregating them into public and private sector
components and the incomes generated in the process. A relevant observation here is the perceived
higher returns to external assets held by US relative to US assets held by the rest of the world. A
disaggregation enables analysis of the role of private and public sector in perpetuation as well as the
resolution of imbalances. There could be dominance of bilateral claims of the private sector of one
country to the public or the private sector of other country. Could such dominant bilateral claims
become a noticeable force allowing, at times, non-economic factors to play a role in the whole process
of engagement?
Second, following the experience of the East Asian crisis of 1997-98, where private sector
vulnerabilities rather than public sector imbalances played a key role in precipitating the crisis, the third
generation models have explicitly brought to the fore the role of balance sheet mismatches in causing
financial crises. A country's balance sheet as evident from traditional macroeconomic aggregate could
be quite sound, yet, analysis of composition and size of the liabilities and assets of the balance sheets
of domestic entities may be useful in assessing vulnerability to the manner of unwinding of
imbalances. It would therefore be useful to analyze the impact of global imbalances on various
balance sheets within the country such as the government sector, financial sector including banks and
financial institutions, non-financial private sector including corporates and households.
Third, as mentioned earlier, surplus of oil exporting countries has emerged as a new factor in the
debate on the global imbalance. There are some indications that the oil surpluses are being deployed
in more diversified avenues than official reserves. Oil exporters appear to have taken advantage of
emerging investment opportunity in stock markets and real estate. Such inflows could have helped to
keep long-term interest rates as also emerging market bond spreads low, even as policy rates are
rising. An interesting issue would be the nature of their responses to unwinding of global imbalances.
Fourth, in a way global imbalance is a reflection of incomplete globalization. If there were complete
globalization, the surplus in saving of one country could be utilized by a country which has deficit in
saving as it happens among different States in India or the US. It could be argued that as the global
economy integrates further, the resolution of the global imbalances might be smoother.
Fifth, what is the evolving role of viewing exchange rate regimes in influencing domestic economy? It
is argued by some that the emerging evidence indicates that domestic price movements remain
somewhat immune to considerable exchange rate movements. If so, the possibility of bringing about
global rebalancing through exchange rate adjustment by itself may not be very encouraging. No doubt
exchange rate would have an important role to play in global rebalancing, but the issue is its
relationship with other components of the whole package like saving-investment, fiscal deficit, raising
investment, structural reforms and domestic output as well as employment. The linkages among the
various components described here could be very country specific.
Sixth, there is wide diversity among the Asian economies in terms of saving and investment rates,
fiscal deficit, drivers of growth (domestic versus external demand) and the degree of flexibility in their
exchange rates. Thus, it may be difficult to treat all of them as contributing to global financial
imbalances, in the same manner, nor would all the Asian economies be identically affected by the
adjustment of global financial imbalances. Correspondingly, the policy response of each country to the
issue would be tailored to the circumstances. More importantly, with growing integration among Asian
economies, how would the process of rebalancing affect them depending on the manner in which
dominant economies in Asia manage the process?
Seventh, our Prime Minister, Professor Manmohan Singh has suggested that given the potential for
investment demand in the region, we must find ways of making better use of savings and finding
investment avenues within the region. In this regard, an important issue would be generation of
demand within the region so that the aggregate current account surpluses are absorbed in the region
itself. This process of demand generation would help in orderly correction of the global imbalances
Eighth, one wonders whether there is a dissonance between the perception of financial markets and
that of the policy makers in regard to global imbalances. The policy makers appear to give some
signals of concern, but the response of the financial markets is often out of alignment with the signals.
Interestingly, anecdotal evidence shows that analysts in financial intermediaries are sensitive to the
downside risk of imbalances, but the conduct of the participants does not reflect the awareness. No
doubt, this sense of dissonance is not new, as for example, stock markets went up after Mr. Alan
Greenspan's statement regarding irrational exuberance. If such dissonance is true, and persists, what
would be the effectiveness of public policy initiatives?
Ninth, is there an advantage in assessing the non-quantifiable factors to explain the persistence of
what has been stated as a stable disequilibrium to describe the current status of the global economy?
For example, signature value of United States in terms of confidence of financial markets as a lasting
safe-haven status could be a factor, though the issue is whether it will be valid interminably. The
perception of continuing productivity gains in the US due to its proven flexibilities could be another.
Lack of alternatives to deploy global savings, which are expanding may also be relevant. No doubt,
these are not quantifiable, but do not cease to be relevant for analysis and assessment.
Finally, is it possible that there are several intermediate scenarios between orderly adjustments and
disruptive or disorderly adjustments? A series of marginal adjustments, often in spurts, could take
place which may appear random, but move towards gradual lessening of imbalances through an
interactive and iterative processes encompassing markets, national policies and global cooperation.
The agenda for analysis proposed here may facilitate exploration of such intermediate scenarios of
unwinding global imbalances.
Conclusion
To conclude, the performance of the Indian economy since 1980, and in particular since the reforms in
the 1990s, is in many ways an impressive success story both in terms of growth and stability. The
Indian economy has responded well to the rising global competition with gradually increasing
integration with the world economy. The current high growth phase of the Indian economy is also
coinciding with rising domestic saving rates. While India by itself hardly contributes to the current
global financial imbalances, any large and rapid adjustments in major currencies and related interest
rates or current accounts of trading partners could indirectly, but significantly, impact the Indian
economy. We therefore have a large stake in the process of unwinding of global imbalances, and we
are willing to play our part in ensuring successful outcomes from current initiatives.
Thank you.