1. GLOBAL IMBALANCES Notes for Discussion Guillermo Calvo October 20, 2005

2. “Here's what I think will happen if and when China changes its currency policy, and those cheap loans are no longer available. U.S. interest rates will rise; the housing bubble will probably burst; construction employment and consumer spending will both fall; falling home prices may lead to a wave of bankruptcies (...). In other words, we've developed an addiction to Chinese dollar purchases, and will suffer painful withdrawal symptoms when they come to an end.” Major Advocates: Krugman; Obstfeld & Rogoff; Roubini & Setser; Eichengreen Paul Krugman Hard Landing Hypothesis

3. USA External Deficit Financing Reflow of Private Capital to EMs Current Account -700 -600 -500 -400 -300 -200 -100 0 -414 (billions of US dollars) Crisis in EMs “Neoclassic” Period Private Financing Official Financing -100 0 100 200 300 400 500 600 700 800 19921993199419951996199719981999200020012002 -14 -100 0 100 200 20032004 246 167 Source: WEO 679 -666

4. 31% 24% 20% 7% 3% 0% 5% 10% 15% 20% 25% 30% 35% ChinaJapanRest of Asia*Middle East** Latin America 15% Others International Reserves Accumulation Prima Facie, Asian Central Banks... Who is Financing the Current Account Deficit of the US? 2000 2001 2002 2003 27% 57% 71% 88% Reserve Accumulation in US Dollars Reserves in US dollars over total reserves, average 1992-2003: 63% (in % of the US Current Account deficit, 2004) *Includes: Korea, Hong Kong, India, Indonesia, Malaysia, Philipines, Singapore, Taiwan y Thailand. **Includes Oil Producers: Bahrain, Iran, Kuwait, Oman, Qatar, Saudi Arabia, Syria, United Arab Emirates and Yemen.

5. How Do They Do It?

6.  Non-US central banks buy US Treasury bonds by issuing their own debt to:  Private sector, or  Other banks who use private sector deposits.  Thus, directly or indirectly, private investors lend to US government!!

7. 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% How was International Reserve Accumulation Financed? 2003 Senioriage Revenues in % of International Reserve Accumulation JapanKoreaChina 2004 20032004 2003 2004 Fiscal Deficit In % of GDP Japan Korea China 20032004 2.5%1.5% 7.9%6.7% 1.7%2.0%

8. What If Asia Floats? (Krugman’s concern)  If Asia floats, then Asian central banks stop buying US public bonds,  and, therefore, the private sector will buy US public bonds directly, instead of indirectly (as before).  Thus, if private sector demand for public sector bonds remains unabated (a reasonable assumption), Krugman need not worry...  Unless, of course, political and other considerations generate high market volatility.

9. Moreover  Interest rates on long-run US public bonds are not unprecedentedly low, and  The US public sector is not heavily indebted, compared with other industrialized countries.  The private sector savings have already undergone a large increase.

10. -6,0 -4,0 -2,0 0,0 2,0 4,0 6,0 8,0 10,0 12,0 Jan-55Jan-57Jan-59Jan-61Jan-63Jan-65Jan-67Jan-69Jan-71Jan-73Jan-75Jan-77Jan-79Jan-81Jan-83Jan-85Jan-87Jan-89Jan-91Jan-93 Jan-95 Jan-97Jan-99Jan-01Jan-03Jan-05 US Interest Rates: A Long Run View ( real interest rate, 10-year US Treasury Bond, Jan-55 – Jun-05 ) Average: 1.8 Average: 1.7 2.0

11. Public Debt in Industrialized Countries (Central Government, in % of GDP) 160% 101% 53% 40% 39% 37% 0% 18% 36% 54% 72% 90% 108% 126% 144% 162% 180% JapanItalyFranceGermanyUKUSA US Public Debt is Still Small

12. US Twin Deficits: Ricardian Equivalence? (In % of GDP) -6.0% -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% Mar-90Mar-91Mar-92Mar-93Mar-94Mar-95Mar-96Mar-97Mar-98Mar-99Mar-00Mar-01Mar-02Mar-03Mar-04Mar-05 -6.0% -5.0% -4.0% -3.0% -2.0% -1.0% 0.0% 1.0% 2.0% 3.0% Current Account Fiscal Result Current Account Fiscal Result Post EMs Crises Post US Recession

13. The Changing Anatomy of the US External Imbalance Savings & Investment Private and Official Current Account (% of US GDP)

14. Assessment  The current imbalances are sustainable, even if non-US central banks stop buying US public debt obligations, if private sector propensity to buy public sector bonds remains largely unchanged.  Given current low interest rates, Emerging Markets will become magnets for capital flows.  This may give rise to higher investment and growth in EMs but  given their small size compared to the US, this trend will likely have little impact on interest rates,  unless the US fiscal deficit shows no downward trend

15. GLOBAL IMBALANCES Notes for Discussion Guillermo Calvo October 20, 2005