Global imbalances and valuation effects

With global imbalances starting to decline and a falling US $ it is timely to look at some of the possible macroeconomic effects. A recent series of papers (see authors Lane, Milesi-Feretti, Gourinchas, Rey, Tille, Obstfeld, Rogoff etc.) focused on valuation effects in addition to traditional transmission channels (which are covered by the balance of payments).Since gross holdings of external assets and liabilities are today much bigger than ever before exchange rate and asset price fluctuations have a much more significant potential to influence the net external position of country. Balance sheets of households, enterprises and governments are increasingly sensitive to exchange rate and asset price variations. For example the United States experienced a slight improvement in its ratio of net foreign assets to GDP between 2001 and 2005, despite running a large current account deficit. Several factors influence the ratio: the trade balance, net investment income, net capital gains (valuation effects), the effects of growth and capital account transfers and errors and omissions.

Lane and Milesi-Feretti (2006) analyze the adjustment of global imbalances and the possible impact on European Economies. They assume three different adjustment scenarios: Soft landing, disruptive adjustment and policy led adjustment and use the IMF’s Global Economic Model. All scenarios include a substantial devaluation of the US $ and therefore, the authors quantify the net dollar exposure of different economies. They find that the United States unsurprisingly gains from valuation effects in all scenarios while the EU will suffer capital losses. However, the EU losses are much smaller than those expected for China and Japan. More interesting than these expectable results is the question how the gains and losses affect the external adjustment. First valuation gains allow regions higher consumption equivalent to the annuity value of such gains. But the size of long-run real exchange rate adjustment would be unchanged relative to the situation without valuation effects. Lastly they address heterogeneity of Europe concerning differences in trade patterns, different financial exposure to movements in the dollar and US asset prices and differences in external positions, which clearly cause different impacts of adjustment among the European States. With respect to valuation effects all European countries are expected to experience a capital loss. The countries most affected are likely to be the Netherlands, Denmark, Sweden, Norway, the United Kingdom and Switzerland.

What follows from the paper for policy makers? “A disruptive adjustment in global imbalances would constitute an asymmetric shock. Real exchange rate adjustment between creditor and debtor members of the euro area would need to be accomplished through differential inflation rates – this would plausibly be a slow process in light of the low inflation rate in creditor countries, and may therefore be associated with more pronounced cyclical slowdowns in debtor countries.“

Literature:

Lane, Philip R. and Gian Maria Milesi-Ferretti (2006), Europe and Global Imbalances