Article written by Prieur du Plessis, editor of the Investment Postcards from Cape Town blog.
This post is a guest contribution by Alan Taylor and Manoj Pradha of Morgan Stanley.
Global imbalances have been falling. But does this reflect the ongoing impact of the Great Recession, or is it part of a deeper trend? While cyclical factors are apparent, we believe that fundamental drivers are playing a more important part in the global rebalancing story.
Going forward, we expect four key trends: (1) Pent-up DM and EM investment demand will re-surface, though to a lesser extent in DM economies; (2) EM reserves are likely to build at a slower pace once EM central banks feel they have an adequate war chest to protect them; (3) Lower private saving flows in EM economies as strategies to enhance consumption and domestic demand gain traction; and (4) Flat or declining saving flows, even in DM economies. Despite deleveraging, total saving may be flat or falling in the US where deleveraging is more serious, and potentially declining in other DMs.
Global sum of parts – what will it all mean? These trends have major implications, we believe. The slow but steady move from current account deficits to current account surpluses in DM (and vice versa in a large part of the EM world) will likely be accompanied by continued EM currency value appreciation in real terms (i.e., this is likely to happen through a combination of nominal appreciation of currencies as well as a wedge between EM and DM inflation). Finally, global real yields will likely rise as aggregate investment demand booms relative to saving supply.
The next global growth cycle. EM will be looking to push ahead with its investment-growth model, and yet change the mix and magnitude of its current safety-first saving model. DM will be looking to reinvigorate and reinvent its investment-growth strategy and delever, but will face structural headwinds.
How Did We Get Here?
Global trends drove real yields lower… The global imbalances of the last 10 to 15 years reflected trends in underlying saving and investment behaviour at the national, regional and global levels. With the majority of coarse capital controls easing worldwide in the 1980s and 1990s, first in DMs and then in EMs, an increasingly integrated global capital market therefore began to reflect aggregate EM and DM saving and investment trends through the equilibrating movement of a global real interest rates. The message from these yields (proxied by inflation-adjusted real yields) was that saving exceeded investment globally, resulting in a steady downtrend in real yields.
…and exacerbated global imbalances. While both investment and saving worldwide have been on inexorable downward trends since the 1980s, in EM they have been buoyant, and saving has generally been higher, except in the early 1990s. In the DM world, the downtrends in these variables have been sharp, and saving has trended below investment. This resulted in current account surpluses in the excess-saving EM world and current account deficits in the saving-deficient DM world. As the macroweight of DM has been so much larger than that of EM until now, the rising EM saving and investment trends have not yet been outweighed by falling DM trends, but that is already changing.
New trends in town. The new trends we outline below will change the global landscape going forward, with implications for global rebalancing, real yields, exchange rate appreciation and inflation.
Trend 1: Pent-Up Investment Demand – Trend and Cycle?
The drought is over. We can anticipate upward pressure on investment demand from both the EM and the DM economies. We argue that, in the years ahead, the ‘investment drought’ epoch of the last 10-15 years may come to an end.
Cyclical rebound. Investment activity was postponed as the uncertainty of the financial crisis made itself felt via a ‘real option’ as firms took a wait-and-see attitude towards new capex decisions. Now the EM world is in the capex upswing and the DM world is poised to follow. This aspect of the story is essentially cyclical, but given the prolonged depth and length of the Great Recession, it is a phase that may take several years to play out.
Rising share of EM in global investment demand. The EM share of total global dollar-weighted investment rose from 25% in 1980 to 43% in 2009, just as EM dollar-weighted GDP rose from 24% to 31%. As EM economies continue to grow more rapidly than DM, we expect the EM shares to grow further. In a nutshell, DM investment demand will start to matter less, while EM investment demand becomes more important.
Trend 2: EM Reserve Accumulation – Beyond the Step Change?
One key trend that has helped to drive the EM region’s current account surpluses in recent years has been a high level of public saving, whereby policy-makers accumulated substantial foreign reserves as a ‘rainy day’ fund.
Mother of all war chests. We understand these developments as reflecting a necessary ‘step change’ in reserve holdings following the unpleasant shocks of the 1990s and 1997 Asian Financial Crisis. EM economies were exposed as woefully lacking in reserves, and so had to rely in a crisis on fickle global capital markets prone to ‘sudden stops’, or else unsympathetic or inadequate official assistance from the likes of the IMF. The subsequent policy reaction was to steer a course towards ‘self insurance’, but this would require time and effort to amass the necessary backstop – and it has. Over the past 15 years, this build-up of reserves has overshadowed the seemingly natural ‘downhill’ direction of capital flows from rich to poor countries.
Was this a wise move for the EM economies? FX reserves played a crucial role in demolishing the ‘high-beta’ price tag of EM investment. Indeed, we have still not seen any manifestation of any form of crisis in the EM world (banking, currency or sovereign) and the rapid recovery of EM growth stands in stark contrast to the sluggish performance of the DM world. This experience will only reinforce the conviction of EM policy-makers regarding the need to keep reserves on hand, for economic as well political reasons.
But how large a pile of reserves is ‘enough’ to provide this kind of insurance to an EM country? The very fact that all EMs had sufficient reserves on hand to survive the worst global crisis since the 1930s probably tells us as much. The 2008 shocks were a very bad tail event – close to or even on a par with the shocks seen in the Great Depression. We suspect that EMs have now mostly ‘caught up’ with where they needed to be in terms of reserves – the pace of accumulation is therefore likely to slow down to keep pace with GDP or M2 growth going forward. This represents an important insight into the new dynamics of global imbalances going forward: there will be receding pressure on EMs to acquire reserves; that is to say, reduced official sector saving in EM going forward relative to trend.
Trend 3: Lower Private Saving Flows in EM Economies
The lower flow in the build-up of EM public saving is likely to be mirrored in EM private saving flows as well – for very different reasons. There is likely to be a lower precautionary motive for saving due to gradually improving safety nets, financial development, rising wealth, etc. And consumption growth should also find support in demographic trends as many EMs start to confront some of the same aging populations as the DMs. Economic history shows a tendency for saving rates to climb during early phases of development and then peak as countries transition through the middle income stage, and the EM world now finds itself nearing this critical inflection point.
Trend 4: Flat or Declining Saving Flows in DM Economies
In DM, we already see rapid consumer deleveraging, although in some cases the extra saving of the private sector is being offset by additional borrowing in the public sector. This is especially true in the US but less true in Europe, where austerity is now more the norm. However, much of these patterns are cycle-related and not long term, and we might expect most of these adjustments to taper off as recovery takes hold. In order to be convinced, however, we take a closer look at saving in the major developed economies.
Several cross-currents will likely net to a flat US saving picture in next 18-24 months. We expect personal saving as a share of disposable income to rise in 2011 and fall back in 2012 as new fiscal stimulus temporarily adds to saving this year. However, we don’t believe that consumer deleveraging is over – far from it. Rather, it can now proceed at a much slower pace. We expect the saving rate to rise to a 7-10% range over time.
The fiscal stimulus should also boost after-tax corporate saving (undistributed corporate profits) in 2011 at the expense of 2012. Apart from that seesaw pattern, however, pre-tax profit margins are flattening, so earnings growth is beginning to converge to growth in nominal GDP. This is a big deal, as the US federal deficit (or dissaving) will likely peak in the current fiscal year, at US$1.3 trillion or 8.9% of GDP, and decline to US$1.15 trillion or 7.1% of GDP in fiscal 2012. Likewise, state and local deficits as measured in the national income accounts have moved into surplus, although the numbers are small (about 0.4% of GDP this year).
Euroland saving declines. In the euro area, where private households have traditionally been much thriftier than their US or UK counterparts, the personal saving rate looks likely to decline slightly over the next year or two. With unemployment having peaked and job prospects improving, households are likely to reduce precautionary saving and consume a larger fraction of their income. Similarly, the corporate sector, which built up large cash balances over the past couple of years, is likely to save less in the next few years as the focus shifts increasingly towards expanding capacity, hiring and returning cash to shareholders through dividends.
Outside the peripheral countries in crisis, we don’t see any major fiscal tightening on the horizon. Most governments in Europe are in fairly weak positions domestically, with either slim or no majorities, or major elections on the horizon, which makes it difficult for them to push through tough spending cuts or tax increases, even if they wanted to.
Japan flat. In Japan, the personal saving rate should also decline somewhat this year and next, from 5.8% of disposable income in 2010 to 4.8% next year, on our team’s latest forecast. This should be roughly compensated for by lower public dissaving as the budget deficit looks set to shrink.
Global Sum of Parts: What Will it All Mean?
Our three major calls highlight the implications of the great rebalancing story:
1. Global imbalances should continue to moderate. EMs’ excess saving (i.e., the excess of saving over investment) is likely to moderate, as their growth dynamics push continued investment demand. The origins of demand will shift from export-led to domestic-driven. National saving will fall as (i) households spend more, with less precaution and more demographic pressure, and (ii) central banks pile up reserves but at a more modest rate. From a longer-run perspective, EMs survived the worst global crisis in 80 years with nothing more than a scare. And with all their backstops in place, we believe that EMs are now positioned to exploit the more robust and less externally dependent growth environment they have created.
In the DMs, the situation is very different, and growth dynamics are more sluggish in the longer term. Investment there should still rebound, and after the urgent deleveraging of the last couple of years we think the augmented saving rate flattens off under demographic pressure and ongoing fiscal policy support. The investment drought and saving glut dynamics of the last decade are therefore likely to reverse.
2. Real EM exchange rates should continue to appreciate… The second call concerns real exchange rates, and it entails a surprise that’s more backward- than forward-looking. Despite all the talk that EMs have not been allowing exchange rates to adjust to rein in global imbalances, the data indicate otherwise. Since 2003, real appreciation has been the norm, reversing the prior trend, and we think at a rate that is much larger than productivity alone might suggest. For sure, the crisis and the Great Recession interrupted this aspect of the rebalancing process, via the transitory flight to the US dollar, but the fundamental drivers that started the rebalancing process since 2004 have proven strong enough to re-initiate the longer-term trend.
This trend is likely to intensify as EM takes a greater weight in the global economy and switches to a less export-led model. Now EM will bid for more DM goods, and the DM currencies will depreciate in real terms to permit this: it will not be, and has not been so far, a so-called immaculate transfer, where global imbalances adjust without corresponding price movements.
…but through a different mix. EM economies could achieve real appreciation in their currency values through nominal appreciation or they could allow inflation to stay above DM inflation (or both). While the overall need for global rebalancing is satisfied by real exchange rates being moved by either nominal exchange rates or inflation, the mix is clearly important for markets. The bulk of the movement in the real exchange rate so far has been more through the inflation channel than the nominal exchange rate channel, but that trend might change. To the extent that nominal currency values appreciate, inflation will have less work to do.
The most likely outcome seems to be a combination of nominal appreciation as well as inflation. But EMs face a perfect storm of added inflationary pressures in the near term, owing to cyclical recoveries being inflationary, and given extra-fast relative growth with an DM-EM two-track recovery, transitory food and raw material price shocks, and the added longer-term forces working through the global rebalancing channel. Given the potential for social and political disruption from high inflation, EM policy-makers may be forced to rethink the inflation-appreciation trade-off. Thus, EM nominal appreciation may be closer at hand, especially among surplus economies with very little slack in the economy (read AXJ), with China likely to be the strategic ‘first mover’ in that bloc.
3. Global real yields to rise. The last 10 to 20 years of global macroeconomic evolution have been characterised by falling real yields. But this remarkably supportive environment of abundant and cheap global capital could be nearing an end. We highlight the confluence of forces and what they mean.
Our first trend was pent-up DM investment demand. Once this capex cycle is eventually unleashed, the cost of capital will rise as DM economies return to growth and compete with EM economies for investible funds, raising the real interest rate, all else equal. Our second trend was a possible tapering off in EM public saving. Should that occur, as the pace of EM reserve accumulation tapers off, then global saving supply moderates and, specifically, the DM government bonds previously absorbed now start to crowd out global investment by raising the real interest rate, all else equal. Our third trend only exacerbates the first and second: private saving is likely to move lower in some EMs as consumers moderate their precautionary tendencies, and we could see expanding private investment in other EMs – with both factors serving to reduce the excess supply of saving. For all three reasons, the real interest rate seems likely to rise.
Thus, our medium-term prediction is for a reversal of all of the notorious macroeconomic and financial tendencies of recent years: no more saving glut or investment drought, no more bond conundrum or cheap capital. In many ways, then, we anticipate something of a return to the pre-2000s normality, with positive and rising global real yields.
Conclusion
The trends we have outlined have very clear implications: we believe that they will lead to further moderation in global imbalances, further real currency appreciation for EM, and higher real interest rates globally. Higher investment and lower saving in the EM world are likely to draw capital there to pursue higher returns. In our view, these sustained capital flows and EM economic outperformance set the stage for further appreciation of EM currencies in nominal and real terms.
Global imbalances have been falling for some time. While cyclical factors have clearly played a role of late, we believe that deeper fundamental drivers are still the more important factors in the global rebalancing story. The trend in real exchange rates is a key supporting point for our thesis.
Finally, we argue that wider investment-saving gaps in the EM as well as DM economies mean that competition for loanable funds will be more intense. A direct consequence will be higher real rates. Real rates could also rise because of higher macro risk premia, but we highlight the change in investment and saving trends as a benevolent driver of higher real rates. Importantly, this would represent a break from the 30-year trend of falling investment and the consequent fall in real interest rates.
Given that the rise in real yields will represent an increase in productive capacity in EM and DM economies, rather than a rise in macro risk premia, we believe that higher real yields will not prove disruptive for the global economy and will allow the rebalancing we have mentioned to proceed.
Source: Alan Taylor and Manoj Pradha, Morgan Stanley, February 18, 2011.
The Great Rebalancing was first posted on February 21, 2011 at 7:00 am.
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