Will the narrowing of global external imbalances last?

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November 10th, 2014

During the years prior to the start of the great economic crisis, the widening of global current account balances was a cause for concern due to the worldwide risk of sudden disorderly correction. Almost ten years later the substantial narrowing observed in these imbalances could lead us to believe that the problem had been solved. However, far from resolving itself, what has actually happened is that the debate has altered, today revolving around how long this external adjustment will last. In other words, once the recovery has built up steam and spread, will external balances bounce back to where they started? Or, on the other hand, will their correction be permanent? In its most recent World Economic Outlook (WEO), the IMF makes some interesting points in this respect.

Broadly speaking, the sum of current account imbalances (adding together surpluses and deficits in absolute terms) has gone from 5.3% of world GDP in 2006 to 3.4% in 2013. In addition to the evident narrowing of imbalances, of note is also the fall in the concentration of deficits in just a few economies. While, in 2006, the five countries with the largest deficits accounted for 80% of the total deficit, in 2013 these accounted for less than 65%. At a country level, the US has led the field in large external imbalance adjustment. It was and still is the country with the largest current account deficit in absolute terms but, between 2006 and 2013, the US economy deficit shrank by half (from 807 to 400 billion dollars, from 1.6% to 0.54% of world GDP). At the other end of the scale is China, the country with the largest surplus in 2006, which also made a large contribution by cutting its positive balance in terms of world GDP by almost half (from 0.46% of world GDP to 0.25%) and now ranks second in surplus terms after Germany, which has hardly moved in terms of its external balance. Lastly Japan, also on the side of large surpluses in 2006, posted a current account deficit in November 2013 for the first time since 1980.

The IMF has attempted to determine the nature of this correction to predict just how far it might reverse in the future. To this end it has focused on two ways (not mutually exclusive) that external imbalances are adjusted: via a drop in domestic demand, particularly pronounced in some countries, and via changes in the composition of demand.1 When imbalances have narrowed primarily due to a fall in demand, they are likely to widen again as this is essentially a temporary phenomenon. However, the opposite would be true if the adjustment were due mostly to a change in demand's composition. The slump in domestic demand in deficit countries has undoubtedly played an important part in the correction but there are also structural factors that suggest a substantial proportion of this correction will remain in the long term. The main factors are: (i) the decrease in potential GDP of some large deficit countries; (ii) the reduction (at a global level) of policies encouraging significant external distortions; and (iii) energy shocks in the US and in Japan. Without doubt the harshness of the crisis has caused permanent damage to numerous countries' potential output so that, once these economies recover and get back to operating at full capacity, their actual output will still be lower than in the past and, consequently, their external imbalances will also be smaller.

It is also worth noting that, during the period analysed, either as a result of the nature of the crisis or in parallel to it, some of the practices that used to distort external imbalances have disappeared. One significant example is the value of the yuan, a currency that used to be accused of being undervalued in order to promote China's exports (and therefore a larger external imbalance). The Chinese government's commitment to changing the country's economic model towards a system where domestic consumption plays are more important role is yet another reason to believe that the adjustment in China's current account balance will last.

Lastly, the substantial increase in the production of shale gas and oil in the US has had, and will continue to have, positive implications for reducing the external deficit of the world's leading economic power. On the other side of the world, the nuclear moratorium established in Japan after the terrible accident at Fukushima will mean that a large part of the shift occurring in the country's trade balance will remain.

In short, although global external imbalances are likely to widen again in the future, the IMF's projections point to half the adjustment remaining. Such continuity is not only due to the fall in potential output of some large economies, clearly an undesirable effect of the crisis, but also to the fact that policies distorting countries' external balances have been successfully reduced.

1. Changes in a country's production structure can also alter external imbalances.