Wednesday, March 30, 2011

Global Rebalancing

Concerted discussions by G20 countries to formulate a cohesive monetary policy are slowly at work. Recent comments by Bank of Canada Mark Carney on high levels of capital flows, a demand-driven commodity boom, emerging market inflation, and the transfer of such inflation to developed markets like Canada's, supposedly gave stock markets a reason to take pause earlier this week.

An interesting article by Manoj Pradhan and Alan M. Taylor of Morgan Stanley argues that the "global savings glut", where capital flows to emerging markets (EMs) return "uphill" to developed markets (DMs) in the form of asset purchases, are unlikely to continue at previous pace.
Capital flowed “uphill” from poor to rich countries — EMs saved more than they invested, the excess showing up as current account surpluses (net exports of EM goods) and financial outflows (net acquisition of DM assets). But digging deeper exposed a crucial fact: private capital still flowed “downhill” to EM economies in line with intuition, but offset by even larger “uphill” official flows, the reserves bought by EM central banks and sovereign wealth funds.


While EM reserves might still grow gradually to track EM expansion, a continued aggressive step-change to augment reserves relative to GDP seems unlikely, as current war chests are evidently large enough to cope with severe macroeconomic disasters.
Why is this important for Canadian housing? It's not a coincidence that low interest rates have been helped by increasing demand for treasuries by those abroad who have saved. If their saving patterns look to be shifting into investment, that should produce higher interest rates for government debt.

The article concludes:
...we see lasting consequences beyond those unfolding in the immediate aftermath of the financial crisis:
  • A huge rise in demand for capital in EMs with a more moderate increase in DMs. Talk of a savings glut or an investment drought may recede. The global real interest rate is likely to rise.
  • Less saving flows out of EM economies. Growth prospects are the main driver but risk premia for newly resilient EMs may fall. If investment demand is muted in DMs, and saving flat, the shift is weaker in DMs. Global imbalances moderate, reinforcing the trends after the crisis.
  • These current account shifts cannot be an “immaculate transfer” without real exchange rate adjustment. Recent real appreciation of EMs took the form of relative inflation and managed currencies (the latter creating political distractions). But EMs are likely to absorb further adjustment through nominal appreciation, given a triple whammy of cyclical reflation, growth differentials pushing nontradable inflation and oil/commodity price shocks.
Despite ongoing developed world unemployment issues, high commodity prices, and serial developed world sovereign debt crises, it's useful for us to remember the global economy will eventually start to recover in earnest and pay more attention to productive investment, and this can happen relatively quickly.

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