Mark Carney: The paradigm shifts - global imbalances, policy, and Latin
America
Remarks by Mr Mark Carney, Governor of the Bank of Canada, at the Inter-American
Development Bank, Calgary, 26 March 2011.
* * *
Introduction
Globalization is the opportunity and the challenge of our age. It has the potential to lift billions
out of poverty, vastly expand economic prospects, and develop a more diverse and resilient
global economy. However, globalization also brings stresses, so policy-makers will need both
discipline and new frameworks to realise its promise.
The financial crisis has accelerated the shift in the world's economic centre of gravity.
Emerging-market economies (EMEs) now account for almost three-quarters of global
growth - up from just one-third at the turn of the millennium.
Although this paradigm shift to a multipolar world is fundamentally positive, it is also
disruptive. Labour, capital and commodity markets are changing rapidly. The effective global
labour supply quadrupled between 1980 and 2005 and may double again by 2050.1
Crossborder capital flows have exploded, growing at a rate almost seven times the peak during the
last wave of globalization.2 Commodity markets are in the midst of a supercycle.
Large imbalances are a natural consequence of globalization. These imbalances can be
good or bad. Good imbalances are the product of capital moving to where it can be best
used, production being reoriented and expanded, and the economic cycle becoming more
commodity intensive.
Bad imbalances arise when countries resist or misread the consequences of this shift of
activity and demand from advanced to emerging economies.
Indeed, the response to such pressures will influence the resiliency of the globalization
process itself. In the run-up to the crisis, poor policy choices reinforced vulnerabilities.
Countries frustrated exchange rate adjustment, and the recipients of large capital inflows
squandered them. Price stability was achieved, but financial stability was forfeited. The result
was unbalanced, unsustainable growth, culminating in economic catastrophe.
It is not clear that the commitment to open markets will withstand a repeat of such mistakes.
Today, I will concentrate on two current policy challenges for our region that could prove
decisive:
1) maintaining price stability in the face of a major commodity shock, and
2) maximizing the return to large, volatile capital flows.
In each case, there is a risk that policy-makers downplay longer-term forces when setting
short-term policy. As a consequence, destabilizing global imbalances could re-emerge and
undermine the globalization process itself.
Commodities
Major commodity exporters, including Canada and much of Latin America, are experiencing
a large, positive terms-of-trade shock (see Appendix, Chart 1). Real prices for energy and
metals have been well above their long-term averages for more than five years, and real food
prices are now at their highest levels in twenty years (Chart 2).3
The question is whether such strength will persist.
From a policy perspective, it matters whether prices are being primarily driven by demand,
supply or speculation. In general, supply shocks and speculative overshoots tend to be short
lived and can be looked through. Demand shocks are different.
While there have been supply disruptions due to geopolitical unrest and natural disasters,
and while speculative pressures have reinforced, on occasion, the direction of fundamentally
driven price moves, the Bank's view is that a large, sustained increase in demand is the
primary driver of this boom. The breadth and durability of the commodity rally underscores
this conclusion.
This surge in demand is the result of rapid growth in the emerging world, particularly in Asia
(Chart 3). With convergence still a long way off, the demand for commodities can be
expected to remain robust for some time. Based on the experiences of Japan in the 1960s
and Korea in the 1980s, emerging Asia's energy and metals intensities should gain
momentum.4
Rapid urbanization underpins this growth. Since 1990, the number of people living in cities in
China and India has risen by nearly 500 million, the equivalent of housing the entire
population of Canada 15 times over (Chart 4). This process can be expected to continue for
decades, since urbanization rates in China and India are currently 30 to 50 percentage points
below those in Brazil, Mexico and Canada.
In parallel, a massive new middle class is being formed. The world's middle class is growing
by 70 million people each year and will double to 40 per cent of the global population by the
end of this decade.5 The ramifications will be considerable for a wide range of commodities,
through higher protein diets, refrigeration and travel. Whether it is cars, airports or meat,
consumption and development levels in major emerging markets are currently fractions of
those in advanced economies (Table 1).
Even though history teaches that all booms are finite, this one could go on for some time.
With the demand story intact, the profile of commodity prices will turn on supply. Time will tell
whether new supply will be sufficient, and whether consumption converges at current
Western levels or whether price signals and serious attempts at reducing carbon intensity will
ultimately force a more sustainable equilibrium.
The fundamental issue is that the relationship between U.S. economic activity and
commodity prices has changed, and that this is complicating the policy response for
exporters and importers alike (Chart 5).
Policy implications
All IDB member countries are currently facing some similar challenges, which are best
addressed with an eye to these longer-term trends.
First, large and persistent changes in relative prices will encourage substantial structural
adjustment in all of our economies. In past decades, commodity-price increases were often
driven by strong growth in the G-3 economies. More recently, however, higher commodity
prices have been generated, in large part, from strong growth in emerging markets,
particularly in China (Chart 6). Consequently, commodity importers in our region have had to
face the adverse implications of higher commodity prices, without the cushion of a demand
boost from stronger growth in G-3 economies. Similarly, there is greater pressure on the
manufacturing sectors of commodity exporters coming from the strength in their exchange
rates, again in the absence of traditional demand from the G-3.
Adjustment is inevitable - and it will be substantial. In general, such changes should not be
frustrated, but rather facilitated by policies that enhance economic flexibility.
Second, all countries need to maintain price stability in an environment where G-3 monetary
policy cannot be expected to lead the global cycle. As I will discuss in a moment, a key
mistake would be to let fears of capital inflows and exchange rate pressures dominate the
imperative of domestic price stability.
It is paramount that monetary policy everywhere acts to ensure that inflation expectations
remain in line with medium-term policy objectives. Everything else being equal, higher
commodity prices usually necessitate higher policy interest rates. The degree of the policy
response depends on many factors, including the reasons behind the price increases, the
expected persistence of the shock, and whether a country is a net exporter. Policy-makers
also need to weigh the importance of commodities in the consumption basket (Chart 7), the
historic experience with price pass-through, and how well anchored are inflation
expectations.
It bears consideration that the terms-of-trade shock could be even more disruptive. Most of
us have become heavily reliant on manufactured goods and components from China
(Table 2). For example, in Canada, partly as a consequence of Chinese trade, goods price
inflation has run about 1 per cent for the past decade. However, with commodity prices rising
sharply in China, second-round effects on manufactured goods pricing are possible, due to
rising wages and input costs and, potentially, exchange rate appreciation. Finally, it has to be
considered that the process of globalization, with its large-scale displacement, may actually
reduce potential growth in advanced economies during the adjustment phase.6
Canada has learned through long experience that the role of the exchange rate is crucial. For
commodity exporters, improvements in the terms of trade tend to put upward pressure on the
exchange rate. When such movements in the nominal exchange rate are limited, wages and
a range of other prices respond. This is a more disruptive form of adjustment that can have
profound implications for employment, financial stability and competitiveness - the very
objectives exchange rate management seeks to protect.
Recent experience suggests that many emerging economies are taking the real adjustment
through higher domestic inflation (Chart 8), in part because of concerns over capital inflows.
To the extent that the nominal exchange rate responds, it helps offset the expansionary
effect of the increase in investment, and gives price signals to the production sector for
labour and capital to shift to the areas of higher return.
Capital flows will move to hasten that adjustment, which leads to the second policy
challenge.
Capital flows
Capital can be expected to flow, on a net basis, from advanced economies towards higher
expected risk-adjusted returns in emerging-market economies. Such was the case during the
last wave of globalization at the turn of the twentieth century when Canada, then an
emerging economy, ran current account deficits averaging 7 per cent of GDP over three
decades.
The scale of the potential reallocation today is significant. Investors from advanced
economies are substantially overweight their home markets: advanced economies represent
half of current global GDP, but their equity market capitalization is nearly three-quarters of
the global capital market.7 A reallocation of 5 per cent of advanced economy portfolios to
emerging markets translates into a potential flow of $2 trillion or $400 billion to Latin
America.8 This is eight times current annual flows to Latin America.9
Paradoxically, despite these secular forces, emerging markets are currently net capital
exporters (Chart 9). In effect, there is a large recycling of capital: private capital flows from
advanced to emerging economies are being more than offset by official outflows.10 Central
banks now hold more than 40 per cent of U.S. Treasuries, which delays adjustment at home
and abroad by muting price signals in both locations.
Two dynamics are particularly important. First, the expansion of gross capital flows has
dwarfed that of net flows. For example, since the 1990s the increase in gross flows into and
out of the United States has expanded three times more rapidly than the increase in net
flows.11 Emerging economies are having difficulties absorbing large private flows, while
advanced economies have often misallocated the surge in yield-insensitive gross claims. In
both cases, the scale of movements and the impact of any reversal have important
ramifications for financial stability.
Second, in the face of stimulative G-3 monetary policy and limited nominal exchange rate
appreciation by China, many emerging markets are trying to forestall capital inflows and
delay necessary monetary tightening. This in turn is feeding domestic demand, which drives
commodity prices up further and leads to more generalized overheating. Third-best policies,
including capital controls under the trendy guise of macroprudential policy, are being
pursued.
Arguably, Latin America is the region most affected by these pressures and, therefore, it has
the greatest interest in durable solutions.
G-20 initiatives
Two related G-20 initiatives can help spring this trap: the Mutual Assessment Process (MAP)
and the reform of the international monetary system.
The MAP process stresses countries' shared responsibility to ensure that their policies are
consistent domestically and globally. This process will establish indicative guidelines and
benchmarks to identify instances of external imbalances. Then, using these guidelines, G-20
members will undertake a mutual assessment of their monetary, exchange rate, fiscal,
financial and structural policies.
The immediate focus is to identify short-term policy measures to address global imbalances.
These will likely include:

financial sector repair and reform;

timely fiscal consolidation;
 structural reforms to enhance growth; and

more market-determined exchange rates over time.
Transition to a new international monetary system
The G-20's second imperative is the refounding of the international monetary system, which
has degenerated into an increasingly dysfunctional hybrid of fixed and floating regimes.
There are two options for redress. The first is to enforce the current rules of the game - as
codified in the articles of the International Monetary Fund (IMF) and World Trade
Organization (WTO). While this is possible, enforcing behaviour through trade sanction is
obviously extremely divisive and runs the risk of reversing the globalization process itself.
A more constructive approach - favoured by Canada - is to renew the rules of the game so
that country actions are both predictable and mutually consistent. Given the scale of
transition under way, in our view, it makes sense to agree to the long-term objective and then
implement short-term measures consistent with a transition to it.
Our long-term objective should be a well-functioning international monetary system that
delivers sufficient nominal stability in exchange rates and domestic prices, with timely
adjustment to shocks and structural change.
All countries should accept their responsibilities for promoting an open, flexible and resilient
system. This responsibility includes recognizing the spillovers between economies and
financial systems and working to mitigate them. Fundamentally, it means adopting coherent
macro policies and allowing real exchange rates to adjust to achieve external balance over
time. Indeed, in a multipolar world of global capital and trade, all systemically important
countries and common economic areas should move towards flexible market-based
exchange rates.
These objectives will not be realised overnight. However, informal commitments to improve
the functioning of the current system could be implemented to guide current policy while
maintaining momentum towards the longer-term vision.
Short-term measures
First, as Bob Zoellick has suggested, major advanced economies should reaffirm the G-7
norm for flexible exchange rates without intervention, unless special circumstances warrant
and the action is agreed.12 The reality is that unilateral intervention seldom is effective
without surrendering monetary sovereignty and control over domestic prices. By reaffirming
this principle, advanced economies could set the stage for a broader accord among all
systemically important economies.
Last week's concerted intervention by the G-7 provides an example of these principles in
action. The circumstances were clearly exceptional: movements in the yen had become
disorderly, volatility was excessive, and there were potential adverse implications for
economic and financial stability. To address these problems and in response to a request of
the Japanese authorities, the G-7 acted in concert in foreign exchange markets for the first
time since 2000.
Second, the Bank believes there could be value in agreeing to an informal code of conduct
for capital flows as a precursor to renewing the more formal Articles of Agreement of the
IMF.13 Certain guidelines - in the form of a notional checklist or decision tree - could prove
useful to maximize the cost-benefit of capital controls, from both national and global
perspectives.
Capital controls may be appropriate in certain circumstances. Sudden capital inflows raise
legitimate concerns about currency overvaluation, overheating and, conversely, the
consequences of sudden stops. This is especially true for countries with less-developed
capital markets and weak institutional infrastructures, where the capacities to absorb and
benefit from large inflows are limited.
However, we should all recognise that short-term expediency could take precedence, and
eventually turn back the clock on an open, flexible system. This risk grows more tangible as
emerging economies become more systemically important.
A Code of Conduct for Capital Flows could include the following four elements to guide
countries during the transition to the long-term system:
1. A clear objective to promote a sustainable and effective flow of private capital
between economies in order to facilitate economic growth and prosperity through
the efficient allocation of resources, specialization in production, and diversification
of risk.
2. A decision framework that recognizes that capital controls should not be the first
option. They are a complement to, not a substitute for, macro and macroprudential
policies. Consideration should always be given to adjusting monetary, exchange
rate and fiscal policy, consistent with budgetary and inflation conditions.
3. Principles to guide the design of measures:
Temporary.
a) Time-limiting measures recognize that capital controls create
distortions, adverse market reactions and negative externalities, as well as the
reality that, over time, controls are often evaded. This principle is also
consistent with the positive longer-term fundamentals that are driving capital
flows to emerging market economies.
b) Targeted. Measures should address specific vulnerabilities, such as Korea's
restrictions on foreign exchange derivative contracts.
c) Transparent. An example is Chile's pre-announced buildup of foreign
exchange reserves. Measures should be consistent with the principles and
should be peer reviewed.
4. Recognition of the responsibilities of capital-exporting countries to monitor the risks
run by host institutions with respect to currency mismatches, maturity transformation
and leverage. The Financial Stability Board's current initiatives for both the formal
and shadow banking sectors are central in these regards.
Conclusion
The shift to a multipolar economy is having a profound impact on capital flows and a broad
range of relative prices, including commodities.
Imbalances are the result of advanced and emerging economies not recognising this new
paradigm. Some countries are postponing monetary tightening in the hope that old
relationships reassert. Others are resisting capital inflows by misreading the secular for the
cyclical. All appear to be underestimating the scale of what is happening.
Therein lies the risk of another crisis. Avoiding it requires leadership, purpose and legitimacy.
The G-20 is well suited to building global economic co-operation, as the response to the
crisis demonstrated. Resolving global imbalances is a much more complicated challenge.
Countries will need to draw on a sense of common analysis and shared destiny to strike what
Mervyn King has termed a "Grand Bargain" across a host of policies.
The G-20 cannot, however, relaunch the global monetary system by itself. The G-20 can
create momentum: it can take important interim steps; but ultimately, to be legitimate, a new
system will require the concurrence of all IMF member countries. Thus, the perspectives of
member countries of the Inter-American Development Bank (IDB) on the appropriate code of
conduct for capital flows and on financial reforms are essential.
The stakes are very high. The current dynamics of commodity prices and capital flows create
major risks to financial stability and sustainable growth across our region. When large
economies with undervalued exchange rates keep their currencies from appreciating, others
feel pressured to follow. Over time, macro policy becomes contorted: exchange rates more
inflexible, monetary policy more hesitant, and economic controls more prevalent. The
collective impact of this behaviour risks inflation and asset bubbles in emerging economies
and, over time, subpar global growth.
Neither outcome is in the global interest. Neither is consistent with IDB principles.
IDB countries can help lead a co-operative approach by their example and influence. The
transformation of Latin America during the past decade has been nothing short of
remarkable. Greater reliance on policy frameworks, enhanced economic flexibility and
decisive action have fed superior macroeconomic outcomes and economic resilience. During
coming challenges, others would do well to draw on the lessons so evident in this room of
the virtues of openness and sound domestic policies.
Appendix
BIS central bankers' speeches

BIS central bankers' speeches
BIS central bankers' speeches