'Doom sayer' Stephen Roach's talk about 'complacency'

The IMF has just confirmed “the continued resilience of the global financial system”. Does that mean that everything is fine and there is no need to worry?

Stephen Roach: With a record US current account deficit still holding at 6.6% of US GDP in mid-2006 and with the price differential between risky assets (i.e., corporate credit and emerging market debt) and riskless assets (i.e., sovereign bonds) at historic lows, this is hardly a time for complacency. Overly accommodative central banks have pushed the global liquidity cycle to excess -- in effect, funding the resilience of the global financial system with cheap money. With central banks now seeking to normalize monetary policies, that excess liquidity will get withdrawn -- posing a much more challenging climate for world financial markets and the global economy. A turn in the global liquidity cycle is precisely the time when we should be worrying the most.

Are market participants assessing the risks in financial markets adequately, or are they lulling themselves in a wrong sense of security?

With the demographic clocking ticking louder and louder at just the time when returns on traditional investments have declined, looming unfunded pension and retirement obligations have led to an extraordinary imbalance between assets and liabilities. Yield-hungry investors have, as a result, moved further and further out on the risk curve - increasing their allocation to higher yielding assets such as commodities, emerging markets, and what we have traditionally called “junk bonds.” In some segments of these traditionally riskier asset classes, the fundamentals have undoubtedly improved. But I am worried that yield-seeking investors have become indiscriminant in their appetite for yield and assessment of risk - not differentiating the secure investments from the weak ones in riskier asset classes and, as a result, lulling themselves into a false sense of security.

What are the biggest risks to global financial market stability?

The growing drumbeat of protectionism is, by far the biggest risk. Economic nationalism is on the rise in Europe and China-bashing is in full swing in Washington. Since, the beginning of 2005, the US Congress has introduced 27 pieces of legislation that would impose trade sanctions of one sort or another on China. The recent withdrawal of the so-called Schumer-Graham tariff threat to China, does not defuse this broad bi-partisan political threat. If any of the remaining 26 actions are enacted - a serious possibility in a highly politically-charged climate that is rooted in the persistent near-stagnation of real wages - China could well reduce its appetite for dollar-denominated securities. That, in turn, could pose an immediate and serious problem for the funding of America’s massive current account deficit - an external imbalance that requires fully US$3.5 billion of capital inflows each business day of the year. Absent Chinese buying of US securities, the dollar could plunge, real US interest rates might soar - developments which could push the US and global economies quickly into recession.

The dangers of global imbalances have been stressed for many years. Nothing has happened. Aren’t the risks in this context exaggerated?

The problem has been serious but the consequences have not been - at least not so far. The world has bought time for two reasons: the excesses of the global liquidity cycle and the need for surplus savers to keep their currencies weak in order to maintain export competitiveness. As noted above, the world’s major central banks are now attempting to withdraw excess liquidity. At the same time, the world’s major surplus savers - China, Japan, and Germany are hard at work attempting to stimulate internal demand. That would tend to absorb their excess saving - leaving less foreign capital to send to saving-short America. By drawing comfort from the heretofore-benign consequences of a serious problem, global imbalances are ignored at great peril.

There are voices, particularly in the US, who do not see a problem in the growing US-current account deficit on the one hand and the accumulations of foreign exchange reserves in some emerging markets on the other hand. Do you share that opinion?

The so-called “global saving glut” theory argues that a consumer-led US economy is doing the rest of the world a favor by absorbing excess saving. I think this notion is preposterous. From America’s point of view, the implications are most worrisome - namely a wealth-dependent consumption model that requires low interest rates to push up asset values and subsidize debt service on equity that is extracted from those assets. A key risk is that asset appreciation begets an asset bubble that then pops - putting tremendous pressure on over-extended US consumers. That is a very real threat today as the US housing bubble now bursts. From the point of view of America’s creditors - especially poor developing economies - the risks are equally disconcerting. The financiers of the US spending binge subject themselves to dollar over-weights in their foreign exchange reserve portfolios - leaving them with low-yielding returns, risk of a fiscal hit in the event of dollar depreciation, and excess liquidity for those countries like China who cannot effectively sterilize all their purchases of dollars. And, of course, the large bilateral trade imbalances that are an outgrowth of these imbalances raise the politically-inspired risks of protectionism. There is no “new paradigm” explanation that adequately explains away these growing risks.

Is the current boom of mergers and acquisitions a sound development? At least jobs are not created that way.

To the extent that rising M&A activity is a proxy for an accelerated pace of corporate restructuring, that is good news for productivity change. That was the case in the US in the early 1980s and especially in the early 1990s. It has also been the case in Japan in recent years and now seems to be bearing fruit in Germany. German M&A activity could top US$160 billion per year in 2005-06 - double the pace of the three preceding years. Meanwhile German productivity has increased at a 1.7% average annual rate in the five quarters ending in mid-2006 - a stunning acceleration from the anemic 0.7% trend from 1998 to 2004. Yes, the cost-cutting tactics of restructuring initially put pressure on employment and real wages. But as the productivity dividends are realized, labor has a much better chance in sharing the benefits.

Are private households so heavily indebted (consumer credits, mortgages) that they could become a destabilizing factor if interest rates should continue to rise?

Overly indebted, saving-short American households pose a major risk to the US and global economy. Household sector debt service hit a record 13.9% of disposable personal income in early 2006. The fact that debt burdens are so high in an historically low interest rate climate is all the more disconcerting. It reflects the voracious appetite for consumption and the willingness of US consumers to lever their favorite asset - their home - in order to fund consumption in an income-short environment. It may not even take further increases in interest rates to push debt service into the danger zone. After all, borrowing costs of about US$2 trillion in adjustable rate mortgages (ARMs) will be reset over the 2006-08 period. Inasmuch as a large proportion of such indebtedness was initially taken on at sub-market “teaser rates,” the reset mechanism that takes such ARMs to market rates, will boost household debt service even if interest rates don’t rise further from current levels. Moreover, any shortfall of income growth -- a distinct possibility as the US now enters a homebuilding recession - could exacerbate the pressures likely to bear down on overly-indebted American consumers.

Have the risks to global financial stability changed over time?

There is nothing static about the risks to global financial stability. As disparities between current account deficits and surpluses widen - a disparity that is currently in excess of a record 6% of world GDP - the risks associated with global imbalances undoubtedly mount as well. To the extent that the world relies increasingly on one asset-dependent consumer - namely the American consumer - to prop up the demand side of the global economy, the risks of a post-bubble consolidation of wealth-dependent consumption become increasingly serious. And to the extent that the excesses of the global liquidity cycle have led to a distortion of the price of risky assets - namely emerging market debt and high-yield corporates - a normalization of liquidity poses risks to many of the more popular investments in the world today. In general, to the extent an accelerated pace of globalization in the real economy and in global financial markets has been accompanied by mounting imbalances, the risks to financial stability change dramatically over time - and the current instance, I’m afraid for the worse.

Are the institutional precautions like the Financial Stability Forum sufficient to guarantee global financial stability?

The existence of the Financial Stability Forum is a necessary but hardly sufficient condition for the insurance of global financial stability. It has done a very good job in the area of surveillance. The semi-annual Global Financial Stability Report published under the auspices of the IMF is a very helpful review of the stresses and strains in world financial markets bearing down on both developing and developed economies. But the Forum has nothing in the way of an enforcement mechanism that would put teeth into the review process. I would like to see the frequency of the report increase from semi-annual to monthly and I would also like to see the development of new and more sophisticated metrics for measuring financial market stresses and strains. If “stability thresholds” are breached, the Forum should be more explicit in stating that. A reluctance of officials to sound the alarm out of fear of investor “herding” has created a new moral hazard in world financial markets.

What else would be necessary?

Global financial stability is very much linked to the state of balance on the real side of the global economy. In that regard, the world has a very serious problem with a striking imbalance in the mix of global saving - the United States does none of it (at least insofar as net national saving is concerned) and several developing and developed economies do too much of it (especially China, Japan, and Germany). At the root of this disparity are equally profound imbalances in the mix of global consumption - too much in America and too little in export-led surplus economies elsewhere in the world. The world needs a saving agenda: The US needs to save more and the surplus savers need to save less. In the US, that spells serious government budget deficit reduction and some form of a consumption tax. Elsewhere in the world, there is an increasingly urgent need for structural reforms of labor markets and for efforts to fund the safety-net institutions (i.e., public sector social security and private sector pensions) - both of which are essential to instill thriving consumer cultures. The world needs more than one consumer and it also needs fewer surplus savers.