Global Imbalance Optimism from the IMF

The World Economic Outlook: Spillover and Cycles in the Global Economy has been published by IMF in parts last week. Chapter three was a surprisingly optimistic analysis on the global current account problem called “Exchange Rates and the External Imbalances”. As financial shock troops, the IMF has not been known as positive concerning the issue of global imbalances, but this recent research suggests that the currency and growth adjustments necessary to get the current account imbalances to more manageable levels will not be as great as others have argued.

There are two major parts to this work. The first part shows that advanced economies which have had large current account deficits and then adjustments did not require a substantial decline in domestic growth to make it happen. This case study analysis of countries that have had current account adjustments is compelling. Second, a careful review of the elasticity of import and export prices suggests that large currency declines may not be necessary to affect the trade balance. The argument that only large declines in the currency are required to change the trade balance is overly pessimistic and based on possible faulty assumptions and biases. The mirror image also occurs for those countries that have current account surpluses. The currency appreciation and domestic growth necessary to reduce the imbalance may be less that than what some analysts have suggested

The IMF analysis leads to some investment conclusions:

1. The risk of a significant dollar decline is less likely. The size of the dollar decline necessary to drive a significant current account decline is smaller than expected. Nevertheless, a dollar decline is necessary and will take substantial amount of time, but a dramatic change is not a requirement for improvement in the current account.

2. The funding problem of the current account deficit may be less problematic; thus less pressure on interest rates. The current account deficit problem by itself may not drive domestic interest rates higher especially in those economies that have well structured and integrated capital markets.

3. Recession may not be required to solve the current account deficit problem. While slower growth may be necessary to get the current account closer to balance, the size of the domestic decline in GDP to slow demand for imports may not be as large as initially thought. Countries with high current account deficits have made the adjustment without a deep or prolonged recession.

There are a host of reasons for a dollar decline, such as current slower growth in the US and talk of trade wars, but the global imbalance problem may be less serious than feared.