Macroeconomic adjustment and technological change:
The international context for economic policy28
Dr Catherine Mann
Senior Fellow, Institute for International Economics
Economic policymakers face two types of adjustment challenges emanating from the global economy today: macroeconomic and technological. The macroeconomic challenges involve the global current account and matching domestic imbalances and the magnitude and concentration of financial obligations that have resulted. The technological challenges involve how information technology is changing the nature of trade by fragmenting the production process and enabling the international tradability of services.
These challenges point to areas for medium-term policymaker concern. The macroeconomic imbalances can be rectified through domestic reforms, albeit difficult ones. The longer these reforms take, the greater the adjustment challenges and the greater the exposure to and potential for disruption caused by movements in interest rates and exchange rates. The technological trends point towards greater fragmentation and specialization in the supply-chain, which enhances the need for efficient enabling services to maintain global competitiveness. Successful trade negotiations in the area of services liberalization as well as trade facilitation reforms increasingly are as important as traditional approaches to trade liberalization for goods and agriculture.
As it turns out, the economy that can successfully meet these international challenges, avoid disruption, and increase competitiveness is the economy that has the product, labour, and regulatory flexibility to change and respond rapidly. As well, it is the economy that is built on strong and stable foundations of domestic institutions and of educational attainment and ongoing skill development. This background trigger paper addresses the international context for economic policy. How to achieve the domestic structure that can meet the international challenges are the topics of session two and three in this conference.
It is well appreciated that global markets are integrated; shocks precipitated by one hurts all. Hence each and every country should be interested in rectifying imbalances — both external and domestic — and responding in a positive fashion to technological trends. Policymaker discussion and consideration of joint and common interests can help speed appropriate response — which is exactly the objective of this conference.
Macroeconomic challenges
There are two complementary external imbalances around the world and several frameworks in which to analyse them. One imbalance is the yawning US current account deficit. The other is the widely geographically disbursed but nevertheless persistent net export surpluses with the US. Underlying these external imbalances are internal imbalances in both countries and regions with respect to savings and investment, and domestic demand and production. These real side imbalances are reflected in the composition and distribution of financial portfolios of assets.
These imbalances have continued, indeed deepened, far longer than both researchers and pundits would have thought. In particular, the US current account deficit at about $670 billion and 5.7 per cent of GDP at the end of 2004 falls outside the oft-quoted range of 4-5 per cent after which, research on industrial countries suggests, economic forces tend to narrow the imbalance (Mann, 1999, p. 156; see also Freund 2000). There is somewhat less research on the persistence of global imbalances from the standpoint of the rest of the world, in part because individually most of those imbalances are not so notable.
Regardless of the exact point where economic forces push back hard, few suggest that the trajectory for the US imbalance is sustainable. By construction, neither is the collective path for the rest of the world. That no other country faces as significant a numerical adjustment as the United States should not imply they have an easier task. In fact, just the opposite is likely the case as each country, facing structural rigidities and difficult policy choices, argues that someone else should ‘go first’ and shoulder the burden. However, failure of collective action could precipitate a nasty adjustment process that no one wants.
Overview of global current account and domestic demand imbalances
US perspective
The US current account is driven predominantly by trade in goods and services, which in turn is largely determined by US and foreign income growth, along with relative prices. With respect to growth differentials, movements in the US trade balance have been influenced largely by the degree to which the US and foreign economic cycles are out of sync. In the early 1980s, and again in the early 1990s, the US economy slipped into recession and imports slowed. During those cycles, world growth remained relatively robust, so US exports rose. So, the trade deficit narrowed from both the import and the export side.
During the mid and late 1990s, the US current account widened as relatively anaemic consumption and particularly investment growth in Japan, Europe and other markets around the world dampened demand for US exports while US consumption and investment grew at unprecedented rates and drew in imports. Since the 2001 downturn, US growth rebounded more quickly than did growth in the rest of the world. Moreover, until several years ago, not only did growth differentials support a widening US external deficit, but also relative prices (as proxied by the real exchange value of the dollar) tended to augment the deficit by making imports cheaper and exports more expensive. Consequently, the US trade and current account deficits have continued to widen into unprecedented territory, both in dollar terms and as a share of GDP (Chart 1).
Chart 1: Trade balance and current account balance and the Federal Reserve Real Broad Dollar Index
Source: BEA International Transactions; Federal Reserve Board.
The macro picture of the US trade deficit masks important features of the disaggregated data, which may be of particular relevance to the nature of domestic imbalances in the US and rest of the world (Chart 2). The largest category on both sides of the US trade equation is capital goods and industrial supplies and materials excluding energy, which accounted for 45 per cent of exports and 32 per cent of imports (2004). Up until 1997, this balance cycled through larger and smaller surpluses depending in large part on the US and global business cycles. Since about that time, however, the trade balance in this category has not recovered even as global growth has revived. From a surplus of about $50 billion in 1997, this balance is now in deficit some $50 billion. This change may reflect the initial and continued effects of the appreciation of the dollar. It may be due to slower growth of investment in US exporters’ markets abroad. The international supply-chain for production of capital goods may be permanently changed, perhaps to centre on China. Or, the fallout from the Asian financial crises may be persisting.
Chart 2: US trade balance by end-use categories (US$billion)
Source: BEA International Transactions Data.
*Other includes: foods, feeds and beverages, energy products, and imports and exports nec.
On the other hand, US ‘other private services’ such as education, finance, and business and professional services continue to reveal international competitiveness. The balance on trade in this category of trade (which now accounts for 6 per cent of total imports and 13 per cent of total exports) is positive and has continued to rise despite slow growth and closed markets abroad (for more on services trade, see Mann (2004)).
Although capital goods and services may be the biggest categories of trade flows, the biggest component of the non-oil/non-agriculture trade deficit is in consumer goods, which account for 21 per cent of imports and 8 per cent of exports. When added to the net deficit in autos, nearly three-quarters of the increase in the non-oil/non-agriculture trade deficit since 1997 can be accounted for by these two categories. The structural imbalance in categories of trade may be a reflection of the specific nature of domestic imbalance in the United States, to which we now turn.
As is well known from national income and product accounting, an external deficit has as its counterpart an imbalance between savings and investment, or, equivalently, between production and domestic demand. How is the US current account deficit reflected in the domestic accounts?
For the United States, Chart 3 shows a decomposition of the national income and product accounts into the savings investment balance, with the components of net national savings highlighted. During the 1990s, the narrowing of the fiscal budget, ultimately into surplus, helped finance the increase in investment of that period. In the last several years the fiscal position returned to deficit with about half to two-thirds of the increase in the deficit coming from the significant tax cuts to individuals. As investment rebounded, with insufficient national savings, net foreign savings (proxied by the current account) increased. The most notable structural feature of the national accounts is how private consumption in the US has been robust through periods of both fiscal surplus and fiscal deficit; net household savings has trended downward almost without pause.
Chart 3: US savings and investment
Source: BEA, NIPA tables and international transactions.
Matching-up the domestic and international perspectives for the United States, the trending down of household savings in the domestic framework is reflected in a persistent widening of the deficits in the consumer goods and autos categories in the international framework. Policy choices and economic outcomes have augmented US consumption, at various times through equity wealth, housing wealth, and tax cuts.
Perspective from the rest of the world
For the rest of the world, what does the current account framework for analysing global imbalance tell us? Considering a 25 year horizon, some regions and countries tend toward persistent current account surplus (Japan) and some tend toward deficit (Latin America and Caribbean and Australia and Canada). However, during the 1990s, almost all countries moved toward current account surplus, in some cases dramatically so (Latin American and Caribbean, non-Japan Asia, Western Europe). China’s current account surplus as well has remained high. So, the widening of the US current account deficit has a counterpart in narrowing deficits and widening surpluses in other parts of the world (Table 1).
Table 1: Current account balances as per cent of GDP
Source: IMF World Economic Outlook, April 2005.
When countries’ global current accounts are examined more narrowly through the lens of bilateral trade with the United States, the mirror to the US trade deficit is even more dramatic. Over all countries and regions, there are large, and in most cases increasing, trade surpluses vis-à-vis the US (Chart 4). The widening US trade imbalance is not just about imports from China or Japan, but is broad based across all trading partners. Indeed, the worsening of the bilateral US trade balance vis-à-vis Western Europe is about the same dollar magnitude as with China (1992-2003). Hence, even as the global current account imbalances for the rest of the world are individually relatively small, and hence would not appear to warrant much policy attention, their dependence on the US market for the bulk of the positive improvement in their global current account is quite great and does warrant policy consideration.
Chart 4: US goods balance with selected trading partners29
Source: BEA, International Transactions tables.
Of course, breaking down the region in this way shows the impact on bilateral balances of regional consolidation of much productive capacity in China. But, it is important to note that the region’s growth success is still dependent on the US market, not the Chinese market per se. To show this, Chart 5 puts China (rather than the US) at the centre of global trading patterns and suggests that China is a value added way station for production ultimately destined for the United States (and to a lesser extent Western Europe). Hence, to some degree the explosion in intra-regional trade in Asia is not from ‘home grown’ demand, but rather still depends ultimately on exporting to the US market. Hence without the US market, GDP growth in the Asian region will suffer.
Chart 5: China’s goods balance with selected trading30
Source: UN COMTRADE database.
Decomposing non-US growth into the components of the national income and product accounts confirms what has been observed in the international accounts data. The domestic framework for analysing the global imbalance considers the difference between growth in domestic demand and growth in production. It is common to use growth in GDP as the measure of global economic activity; and this is correct when the objective is to measure global growth. However, when considering global imbalances between the US and the rest of the world, it is important to net-out the US from the global growth equation. Moreover, to the extent that growth in GDP abroad is augmented by a positive net export position, as has already been observed in the systematic move toward current account surplus, growth in foreign GDP will tend to exceed growth in domestic demand.
In fact, there was a systematic trend over the 1990s in the relationship between domestic demand growth and production growth for countries other than the United States (Chart 6). Whereas in the early 1990s, non-US global production was less than non-US domestic demand growth, by the end of the 1990s and to 2003, foreign domestic demand growth fell short of foreign production growth by more than 1 percentage point. Combined with the asymmetry in income elasticities of trade for the US, this unbroken trend narrowing of the gap between non-US global production and non-US global domestic demand is the striking counterpart to the widening US current account deficit and helps explains the region by region net export surpluses with the US.
Chart 6: Rest of the world GDP growth less domestic demand growth
Note: Growth rates of US trading partners, weighted by FRB multilateral trade weights domestic demand: consumption growth weighted at 70 per cent, investment growth weighted at 30 per cent.
Source: Author’s calculations using data from Penn World Tables.
Financial account imbalances
International financial flows offer a third perspective of global macroeconomic imbalances. By the nature of balance of payments accounting, a current account deficit implies net financial inflows from the rest of the world. For the US, these financial inflows have changed in both magnitude and composition in recent years. Moreover, the extended period of US current account deficit (more than 25 years) implies a build-up of net financial obligations to the rest of the world whose composition and geographic concentration also have changed.
The US financial market offers a wide menu of assets: US treasury securities, corporate stocks and bonds, direct ownership of a controlling interest in companies or real estate (foreign direct investment), even currency. The patterns and magnitudes of net purchases of these assets reflect broad trends in the financial marketplace. Foreign purchases of US assets regularly exceed the ‘financing need’ based on the US current account because US investors purchase assets from abroad. For example, in the first three quarters of 2004 (AR), the current account was $640 billion but the financial inflow was $1,334. Equity purchases were particularly notable during the stock market boom years, and the share of US assets in equity portfolios abroad rose from 30 per cent in 1993 to about 50 per cent at the end of 2004 (Economist magazine ‘Portfolio Poll’). Private and official purchases of US government securities resumed when the fiscal budget deficit reappeared and widened dramatically, thus creating renewed net supply of these assets. Indeed foreigners increased their share of the US treasury securities held by the public from 20 per cent in 1990 to 30 per cent in 2000 to about 55 per cent in 2004.
Foreign official purchases of US treasury securities have been particularly notable since 2002 following the peak of the dollar. Such foreign official purchases during times of dollar depreciation are not new. Important foreign official purchases appeared in 1986-1989 and again in the mid 1990s, times when the dollar was experiencing depreciation pressures. However, official purchases accelerated during 2003 and 2004 and are unprecedented in terms of dollar value and as a share of total financial inflow. These foreign official purchases are concentrated by holder, with the share of Japanese official holdings in total estimated official holdings rising from 28 to 37 per cent between 2000 and 2004 and the estimated share of Chinese plus Hong Kong, SAR holdings rising from 16 to 20 per cent of total estimated official holdings (Chart 7 a and b).
Chart 7: Derived official holdings of US Treasury securities | |
(a) March 2000 |
(b) October 2004 |
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- March 2000: Total Official Holdings = US$635.6 billion.
- October 2004: Total Official Holdings = US$1124.7 billion.
Source: US Treasury International Capital System (TIC data).
Memo: Estimated shares of official holdings are derived by assuming that all holdings of PRC are official, all holdings in Caribbean Banking Centres are private, and recalculating weights on other countries’ based on their shares in total holdings.
For the United States, the accumulation of current account deficits yields an increase in the negative net international investment position, which totalled $2.4 trillion as of 2003 (direct investment at current cost). Gross assets (US-owned foreign assets) and liabilities (foreign owned US assets) are, of course much larger at $7.2 trillion and $9.6 trillion respectively. US obligations have several unique features. First, US international borrowing is mostly in dollar denominated financial instruments so a dollar depreciation reduces the value of the debt. On the other hand, this increases the exposure of the foreign holder to deterioration in asset value in domestic currency terms.
Second, earnings on US direct investments abroad regularly have exceeded the returns that foreigners get on their direct investments in the US. Hence the US continues to receive net interest receipts (running at an annual rate of $30 billion in 2004) despite have a negative net investment position. On the other hand, 65 per cent of the financial assets held by foreigners are interest-bearing instruments (including the US treasury securities) whereas only 45 per cent of financial assets held by US investors abroad bear interest. This imbalance in financial holdings increases the exposure of the United States to rising interest rates.
Technological challenges
The past four years, since the bursting of the stock market bubble, may have sobered some on the upside potential for technological change to augment global growth, but there is no doubt that permanent and unceasing transformation based on information technology is underway. Information technology, given the right economic environment, transforms the way markets, firms, and individuals operate and make decisions. Government as well needs to transform activities and policies.
Most research now finds that the main source of benefits from technology is not in the production of technology products, but in their diffusion and effective use throughout an economy. A package of structural policies, networked technologies, and human resources enhances the use and diffusion of information technology to raise the productivity growth throughout the whole economy, rather than just raising the growth of the economy through the IT sector alone.
What policy conditions create an environment where businesses, consumers, and government can effectively use information technology to change their activities and be more productive? An economy needs to have financial depth, external openness, pro-competitive and flexible market regulations, and fiscal efficiency. There is nothing ‘new’ about these policy issues, but one can argue that the synergies are more important now than before and the cost of inaction higher.
Many of these policy areas will be taken up by the other trigger papers. The focus for this one is technological change in the international context with implications for medium-term concerns and policy discussion. Two areas where technological change, in particular information technology, is playing a bigger and bigger role are in supply chain competition and in the enabling of international trade in services.
Supply-chain competition and trade facilitation
The key factor that increases supply-chain competition, with a focus on trade facilitation (the resulting policy issue), is how rapid technological change allows fragmentation and specialization in production. Semi-finished products cross-borders multiple times before arriving at the final buyer. At each juncture, it may not be cost on the production floor that matters most for international competitiveness, but the costs of the logistics of trade — that is issues of trade facilitation.
There is no standard definition of trade facilitation in public policy discourse. In a narrow sense, trade facilitation efforts simply address the costs of moving goods through ports or more efficiently moving documentation associated with cross-border trade. In recent years, the definition has been broadened to include the environment in which trade transactions take place, transparency and professionalism of customs and regulatory environments, as well as harmonization of standards and conformance to international or regional regulations. These move the focus of trade facilitation ‘inside the border’ to domestic policies and institutional structures.
Research conducted by Wilson, Mann, and Otsuki (2003, 2005) investigates the role for four different types of trade facilitation for augmenting trade flows: port efficiency, customs environment, regulatory compliance, services infrastructures. Using a gravity model of bilateral international trade in manufactured products for 75 countries this research compares the responsiveness of trade flows to different kinds of trade facilitation and with respect to own policy action or trading-partners policy action, or both. The research points to what policies might best aid a country’s international supply-chain competitiveness. The answer is enhancement of domestic services!
Table 2 reports on the findings from Wilson, Mann, Otsuki (2005). Column (1) shows the results for all the countries in the sample. Port efficiency of both the importer and the exporter is positively associated with trade. Comparing the effect of port efficiency on imports versus exports, the coefficient is higher for exporters than importer (0.92 versus 0.31), which implies that global trade flows get a bigger boost when the exporters’ port efficiency improves. Customs environment also has a significantly positive association with trade of the importing country with a coefficient of 0.47. Trade facilitation through customs improvements is a possible avenue to reduce the cost of imports even as tariffs remain where they are. Improving the regulatory environment (regulatory transparency and control of corruption) of the importer and exporter has a positive and significant association with trade with coefficients of 0.28 and 0.62, respectively.
Table 2: Regression results (South to South and South to North trade)
Source: Wilson et al (2005).
Improving service sector infrastructure is positively and significantly associated with trade among the studied countries. Similar to port efficiency and regulatory environment, service sector infrastructures have a more significant positive association for export trade than for imports. The coefficient of the exporters’ service sector infrastructure is the highest among all trade facilitation measures (1.94). This high coefficient reflects the important role that services play in all types of trade.
Note that for all the trade facilitation indicators that are paired (that is, are estimated for both exporters and importers), the coefficient for exporters exceeds that for importers. This implies that countries gain more through their own unilateral action, rather than waiting for other countries to ‘open their markets’.
The other two columns of Table 2 evaluate the relationship between trade facilitation and trade for different groups of trading partners: South to North and South to South (where South is comprised of non-OECD members and North is comprised of OECD members). In the South to North panel, many of the variables added to the gravity model for the North (as the importer) are not significant, meaning that most of the gains to South to North trade come from domestic improvements to trade facilitation variables in the South. Moreover, note that the service sector infrastructure indicator has a higher coefficient than in the full sample for both importer and exporter.
Second, compare the South to South panel with the other two samples. Tariffs are once again significant, suggesting that South to South trade is more affected by tariffs than is South to North trade. Regulatory environment appears to be very important for both directions of trade. Looking at all the indicators, the coefficient estimated on the exporter is larger than the full sample and larger than for the importer in the restricted sample, suggesting that trade facilitation efforts could complement more direct approaches to export promotion in the South.
In sum, trade facilitation, particularly through improved services infrastructures has the potential to grow trade by more than tariff reductions alone. Thus, its addition to the set of issues in the Doha round of negotiations makes sense.
International tradability of services
Although international trade in transportation and travel services has always existed, services’ high international transactions costs (measured in time, distance, or otherwise) and functional integral (to an organization’s business activity or product) have tended to make them non-traded. As well, domestic regulations often protect these markets. But, technological change, as well as policy change and changes in customer and business attitudes over time, has eroded these attributes of services — transactions costs and functional integration — that heretofore made them ‘non-tradable’.
Three types of technological change have been important: First, the raw technology of the internet in conjunction with international telecommunications networks and IT hardware (such as personal computers) create the potential for linkages between countries and businesses that simply did not exist before. For example, the average price of an international call between the United States and India dropped in half between 1996 and 2001. The penetration of personal computers into the Chinese marketplace increased nearly seven fold over the same period. Second, digitization of service activities further reduces transactions costs of trade. International trade around the world in such business and professional services grew nearly 40 per cent between 1996 and 2002. Third, ‘codification’ of information puts information into ordered formats which reduce the need for specific knowledge to perform skill — and information intensive tasks. Cheaper internet and information technology, digitization, and codification of information allows many tasks to be separated from the main activity of a business and also makes possible new niches, new products, and new activities for business and consumer.
To a great degree, the forces promoting tradability and hence globalization of services — reduced transactions costs, and fragmentation and separability of business functions — are the same forces that underpin globalization of goods. But, globalization of services may be different from the globalization of goods in three ways.
First, the pace of change in the globalization of services is more rapid than globalization of goods and has greater potential to accelerate (Chart 8). Global international trade in services doubled over the last 12 years (although it still accounts only for about 20 per cent of global international trade) (WTO data). Global foreign direct investment (FDI) in services accelerated over 1990-2002, increasing fourfold to account for about 60 per cent of the global stock of FDI in 2002, up from 50 per cent in 1990 (UNCTAD data). Going forward, trade and investment in services worldwide likely will accelerate because the share of services in consumption tends to rise with the level of income and development.
Chart 8: Global perspective — International services31 | |
It’s not just cross-border activity —
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FDI outward stock: services |
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Source: UNCTAD, World Investment Report 2005.
Second, with both trade and direct investment in services increasing, the share of labour exposed to international market forces is rising. In industrial countries, where services account for the majority of output and employment, rapid globalization of services means that a large and increasing share of the labour force and the productive economy faces international competition. At the same time, in developing countries, more workers are being drawn into the services sector, in part due to globalization and in part as the development process proceeds. In some developing countries, wages adjusted for educational attainment are quite favourable which, in the presence of information technology, digitization and codification, further enhances the potential for international trade in services. All told, an increasing share of the global labour force is engaged in activities that are exposed to technological change and will need to respond to global competition, and the resulting international division of labour.
Third, globalization of services and globalization of goods may differ in how easily firms can change the location of their activities to take advantage of better capabilities in another country. Digitized and codified knowledge of a service activity requires little complementary capital compared with producing goods in a factory. Firms that focus on an intermediate segment of the international value chain in services production (and do not serve the domestic market) are likely to be more foot-loose than factories because their links to the local economy are fewer and physical investment is low.
In sum, services are becoming increasingly important in global trade and FDI, and thus increasing the exposure of domestic business and labour to global competition.
Medium-term concerns
The two previous sections have outlined the nature of global macroeconomic imbalances and trends in technological forces. This section addresses what potential vulnerabilities might result from the imbalances and forces. In particular, the macroeconomic imbalances point to growing vulnerabilities to interest rate and exchange rate changes. The technological forces point to opportunities for and vulnerabilities to international trade competitiveness from the services sectors. I will take as given that there are upward pressures on global interest rates, and depreciation pressures facing the dollar. Moreover, I will assume that the pace of technological change and the diffusion of information technology will continue. These are not incontrovertible assumptions, but they seem the most plausible with which to proceed.
Interest rate and exchange rate vulnerability
The US imbalances in current account, domestic accounts, and financial account suggest two opposing vulnerabilities to rising interest rate and a depreciating dollar. On the one hand, the US negative net international investment position (and its decomposition into interest bearing and non-interest bearing components) points to an increased vulnerability to rising interest rates. Higher interest rates should add net interest payments to the trade deficit and widen the current account deficit (even though the interest component is positive now). But, since most US obligations are dollar denominated, a depreciation of the dollar will reduce the value of the obligations, which would tend to reduce the base on which interest obligations are calculated. Without a doubt, higher interest rates will raise the fiscal deficit (and reduce national savings). Higher interest rates and a depreciated dollar are likely to reduce the magnitude of the trade deficit. Higher interest rates may well slow domestic demand, but a dollar depreciation should offset at least some of the adjustment by increasing demand for exports. On balance, the United States faces a variety of adjustment challenges, but they do not all go in the same direction.
For the foreigners, what kind of vulnerabilities do they face from rising interest rates and a depreciating dollar? In general, the countries that have purchased US assets are likely to see a capital loss on those assets, both on account of currency valuation and on account of lower prices on assets with fixed interest coupons. At the same time, countries are likely to see a reduction in exports and opportunities to buy cheaper imports, with the attendant switch from export oriented GDP growth to domestic demand oriented GDP growth. So, for the countries in surplus and with large holdings of US assets, the adjustment is (except for lower import prices) all one way.
Over the last two years, some countries have started to absorb some of these changes, and others have not. As noted already in the discussion of the financial accounts, some countries have built-up their holdings of US treasury securities to a far greater degree than others. These foreign official purchases of US assets are reflected in different rates of appreciation of individual currencies against the dollar (Chart 9). Currencies that are traded through liquid private markets (such as the Canadian dollar, British pound, Swiss franc, Australian dollar, and euro) have appreciated some 20 per cent (Canada and Japan) to 35 per cent (euro) against the dollar since the beginning of 2002 (when the dollar started a generalized depreciation). For currencies that are not traded widely or in liquid markets (such as the Taiwan dollar, Thai baht, and of course the Chinese renminbi), official intervention can play an important role in affecting currency price. For these currencies, the appreciation has been less or none (China), although more significant bilateral movement has been observed since September 2004.
Chart 9: Nominal average dollar and bilateral exchange rates
Source: Pacific exchange rate service and Federal Reserve Board.
Based on the movements in current account balances, in net exports to the United States, in purchases of US treasury securities, and in arrested depreciation against the US dollar, it would seem that at least some countries in Asia may have, if anything, moved toward increasing their vulnerability to changes in global interest rates and the exchange value of the dollar. The rationale for this strategy could be an ‘insurance policy’ should private markets turn against them again (as they did in the Asian financial crises). More generally, the policy choice to limit current appreciation supports the current economic structure and sources of growth (that is, exports relative to domestic demand). Presumably, these policymakers are doing the calculus to compare the value of economic gains today against the discounted value of (1) future losses on the dollar denominated asset portfolio should the domestic currency appreciate against the dollar plus (2) the presumably rising costs of making real side adjustments to the source of economic activity from exports to domestic demand.
How long might this calculus make sense, that is, to keep the exchange value of the domestic currency depreciated so as to promote exports, recognizing that the longer this policy is pursued the greater the distortion to the underlying economic structure? One way to consider the situation is to compare the evolution of a country’s real effective exchange rate from the time economic reforms started. Presumably, as broad based economic reforms take hold, there is room for exchange rate appreciation and the associated switch to a more balanced domestic growth path.
Chart 10 compares the evolution of real effective exchange rates for two groups of Asian economies (the so called NIEs of the 1980s and the current ASEAN) with that of China. Based on this evidence, it would appear that the Chinese exchange rate regime (and indeed the managed regimes of the other countries as well) has kept its currency undervalued well beyond the time when appreciation is consistent with continued economic reforms — particularly for import competing goods and tradable services sectors — and consequent more balanced growth. To the extent that other economies in the region feel the need to follow suit and arrest their currency appreciation by buying US treasury securities, they all may well be building up vulnerabilities to eventual currency adjustment in excess of what they would have chosen in the absence of China’s choices.
Chart 10: Real effective exchange rates
Source: JP Morgan real effective exchange rate indices.
Time T (beginning year of economic integration) = 100; Source of T: IMF, World Economic Outlook, September 2004.
Services efficiency and trade facilitation
Research on potential gains from trade negotiations makes clear that the United States (as well as developing countries) have much to gain from a Doha round that moves beyond agriculture and market access for manufactures. Table 3 details just how dramatic these gains might be. For the world, the gain from liberalization of services alone is greater than liberalization of manufacturers and agriculture put together $390 billion. For the United States, the gain from liberalization of all services is five times greater than might be obtained from increased market access for manufactures.
Table 3: Estimated gains from trade and investment liberalization
Source: Brown, Deardorf, Stern (2003), Table 2 p. 25; see also Dee and Hanslow (2001).
Memo: Services coverage includes construction, trade and transport, other private services and government services. Protection measured by excess operating profits of firms listed on stock markets. Scenario shows liberalization of implied protection of 33 per cent for all three sectors (agriculture, manufacturing, and service).
Industrial country exporters of services gain in these scenarios that liberalize trade in services. But, the gains to GDP in the developing countries of allowing trade in services are nearly as large as the gains they would get if their trading partners reduced tariffs on the manufactured goods that emerging and transition economies sell into global markets. How so?
Given the generally small size of the services sector in most developing countries, the empirical results mean that the multiplier effect to raise GDP must be larger for services liberalization than for increased exports of manufactured goods. This makes sense given that improved service sector performance increases the competitiveness and efficiency of all other sectors in the economy. All told, the welfare gains throughout an economy from improving domestic service sector performance are dramatic. The estimates of the gains to trade flows of trade facilitation efforts, particularly in services, are consistent with these CGE results.
In fact, simulations on improvements to trade facilitation using the gravity model discussed earlier confirm the potential benefits of trade facilitation and supply-chain logistics for East Asia (Charts 11a and 11b). These are very specific simulations that involve improvements to each trade facilitation variable by an amount unique to each country, specifically each countries’ four trade facilitation variables is improved half way to global average. The findings reveal that the countries of East Asia can have dramatic increases in trade flows through improvements in their own trade facilitation policies. The model estimates indicate that services infrastructures are possibly the most important element of trade facilitation improvement. With tariffs tending downward on average, that leaves a country’s own domestic and possibly unilateral policy choices as the tool for increasing competitiveness of the supply-chain.
Chart 11a: Change in manufacturing exports and imports by region: ‘half way to the global average’ scenario | |
Exports |
Imports |
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Chart 11b: Change in manufacturing exports from domestic and partners’ reform: ‘half way to the global average’ scenario | |
Domestic reform |
Partners’ reform |
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Source for both sets of charts: Wilson et al (2005).
Final observations
The global environment presents two sets of policy challenges: macroeconomic imbalances and trends in technological change. These challenges point to areas for medium-term policymaker concern. The macroeconomic imbalances are increasing vulnerability to movements in interest rates and exchange rates. The technological trends enhance the need for efficient services to maintain global competitiveness.
Economic transition to reduce vulnerability to macroeconomic disruption and enable international trade in services includes reassessment of the exchange rate calculus and increased attention to service sector liberalization. It is in the interest of each country in the region to address the policy choices that have led to these vulnerabilities and instead pursue an economic transition that rectifies macroeconomic imbalances and responds in a positive fashion to technological trends. There is a real disincentive, however, to act alone. A key question, therefore, is: What institutional structure will aid in the collective movement toward appropriate reforms?
References
Brown, D K, Deardorf, AV & Stern, R M (2003), ‘Impacts on NAFTA Members of Multilateral and Regional Trading Arrangements and Initiatives and Harmonization of NAFTA’s External Tariffs,’ in North-American Linkages, ed. R. G. Harris, Ottawa: Industry Canada.
Dee, P & Hanslow, K (2001), ‘Multilateral Liberalization of Services Trade,’ in Services in the International Economy, ed. R. M. Stern, University of Michigan Press: Ann Arbor, pp 118-139
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28 All data current to February 2005 unless otherwise stated.
29 Data current to June 2005.
30 Data current to June 2005.
31 Data current to June 2005.