Last updated: April 29, 2014 6:59 pm


A ripple of hope in a stagnant world

Excess supply and low interest rates go hand in hand and could put the recovery at risk

James Ferguson illustration©James Ferguson


Why are real interest rates so low? And will they stay this low for long? If they doas it seems they might – the implications will be profound: good for debtors, bad for creditors and above all, worrying for the vigour of global demand.

The International Monetary Fund’s latest World Economic Outlook includes a fascinating chapter on global real interest rates. Here are its most significant findings.

First, globalisation has integrated finance. There used to be wide variation in real interest rates between different countries. That is no longer the case, since interest rates everywhere now respond to common influences.



Second, real interest rates – which are adjusted for inflation – have declined a long way since the 1980s. Ten-year rates are close to zero while short-term rates are negative. But the expected real return on equity (estimated from the dividend yield plus the expected growth of dividends) has not fallen by as much. (See charts.)

How is one to understand these developments? The real return on financial assets depends on various factors: how much people want to save and invest; what kind of assets savers prefer to hold; and changes in monetary policy. These are not independent of one another. Above all, central banks charged with hitting an inflation target must respond to shifts in demand by changing their monetary policies.

The IMF reckons that, in the 1980s and early 1990s, changes in monetary policy were the most powerful influence on real interest rates. In the late 1990s, fiscal tightening became the main force driving down real rates

Another important factor was the falling price of investment goods relative to consumption goods. Falling relative prices of information technology mean this is still true.

Since the late 1990s, however, much has changed. In emerging economies the savings rate has gone up, largely because incomes were rising. Investors began to favour assets deemed safe. Most importantly, recent financial crises have caused investment to collapse and private savings to jump in the affected economies.

The IMF argues that declining inflation risk has not contributed to the fall in long-term rates, since the “term spread” – the gap between short- and longer-term rates – has not fallen. More important has been the effect of changes in national savings and investment. At the global level, savings must equal investment. So changes in the observed global savings rate will tell us nothing about whether there has been a growingsavings glut” – by which I mean an excess of desired savings over desired investment. Only a shift in the price – the real rate of interestreveals that.


Strikingly, the 10-year real rate of interest was 4 per cent in the mid-1990s, 2 per cent in the 2000s, before the crisis, and close to zero thereafter. At least two factors lay behind this precipitous fall. Investment fell a long way in high-income economies but soared in emerging ones, especially China; yet the savings rates of emerging economies rose even more than their investment rates. Consequently, these economies became big net exporters of capital.

Emerging countries also largely nationalised this capital outflow. Their governments then tended to buysafeassets, especially to put in the foreign exchange reserves. This helps explain the portfolio move towards highly rated bonds.

The story, in brief, is that shifts in the balance between desired real savings and investment generated a large fall in real interest rates. These were accompanied by changes in portfolio preferences towards safe assets and the collapse in the pre-2000 equity bubble. The shift in the distribution of income towards capital and highly paid employees in high-income countries also weakened demand. The central banks then responded with aggressive monetary policies

These supported explosions of credit generally linked to house-price surges. Both imploded in the crisis. As Lawrence Summers has argued, the high-income economies seem to be worryingly unable to generate good growth in demand without extreme credit instability.

This is not a short-term story. The labelsecular stagnationlooks apposite. The IMF agrees that real interest rates could remain low for a prolonged time

If governments persist with planned tightening of fiscal policies, this seems certain. If investment rates fell sharply in China, global real rates might need to fall still further. That is difficult while inflation is so low.


What might reverse this? The obvious possibility is a jump in investment in high-income countries driven by the relatively high expected returns on equity

The obstacles here are threefold. One is that chief executives are not rewarded for investing for the long term; another is that investment goods are becoming cheaper all the time; and another is that, when the future is uncertain and the economy sluggish, companies rationally prefer to wait before they invest.

Another possibility is a big fall in savings in emerging economies. But this seems unlikely, at least without a collapse in oil prices. 

That leaves the option of sustained fiscal deficits in high-income countries, ideally to be invested in infrastructure. Housing-related credit booms are a far worse option. Redistribution towards the spenders seems quite inconceivable.

If real interest rates do indeed remain low for a long time, creditors are going to find life difficult. But managing the post-crisis public finances should be far easier than the hysterics assume. A really big question in such a world is whether conventional inflation targets might be too low, because they do not give enough room for real interest rates to fall as far below zero as necessary.

The immediate question, however is: how do we generate the demand that is needed to mop up potential global supply? Failure to answer that need in a sensible way was a leading cause of the crisis

Continued failure will blight the recovery or, worse, cause another bout of financial and economic upheaval. Do not imagine these challenges will soon vanish. They look like a semi-permanent condition.


Copyright The Financial Times Limited 2014.


The Return of the Renminbi Rant

Stephen S. Roach

APR 29, 2014
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Newsart for The Return of the Renminbi Rant


NEW HAVENChina’s currency, the renminbi, has been weakening in recent months, resurrecting familiar charges of manipulation, competitive devaluation, and beggar-thy-neighbor mercantilism. In mid-April, the US Treasury expressedparticularly serious concerns” over this development, underscoring what has long been one of the most contentious economic-policy issues between the United States and China.

This is a timeworn debatepolitically inspired and grounded in bad economics that does a serious disservice to both sides by diverting attention from far more important issues affecting the US-China economic relationship. Taken to its extreme, America’s accusations risk pushing the world’s two largest economies down the slippery slope of trade frictions, protectionism, or something even worse.

First, the facts: Since hitting its high watermark on January 14, 2014, the renminbi has depreciated by 3.4% relative to the US dollar through April 25. This follows a cumulative appreciation of 37% since July 21, 2005, when China dropped its dollar peg and shifted its currency regime to a so-called managed float.” Relative to where it started nearly nine years ago, the renminbi is still up 32.5%.

Over the same period, there has been a dramatic adjustment of China’s international balance-of-payments position. The current-account surplus – the most telling symptom of an undervalued currency – has narrowed from a record 10.1% of GDP in 2007 to just 2.1% in 2013. The International Monetary Fund’s latest forecast suggests that the surplus will hold at around 2% of GDP in 2014.

Seen against this background, US officials’ handwringing over the recent modest reversal in the renminbi’s exchange rate appears absurd. With China’s external position much closer to balance, there is good reason to argue that the renminbi, having appreciated by nearly one-third since mid-2005, is now within a reasonable proximity of “fair value.” The IMF conceded as much in its latest in-depth review of the Chinese economy, which calls the renminbi moderately undervalued” by 5-10%. This stands in contrast to its earlier assessments of “substantialundervaluation.

America’s fixation on the renminbi is a classic case of political denial. With US workers remaining under intense pressure in terms of both job security and real wages, politicians have understandably been put on the spot. In response, they have fixated on the Chinese component of a long-gaping trade deficit, charging that currency manipulation is the culprit to the long festering woes of the American middle class.

This argument is politically expedient – but wrong. The US trade deficit is a multilateral imbalance with many countries102 in all not a bilateral problem with China. It arises not from the alleged manipulation of the renminbi, but from the simple fact that America does not save.

Lacking in domestic savings and wanting to grow, the US must import surplus savings from abroad, and run massive current-account deficits to attract the foreign capital. And that leads to America’s multilateral trade imbalance. Yes, trade with China is the largest component of this imbalance, but that largely reflects the complexity of multinational supply chains and the benefits of offshore efficiency solutions.

That brings us to the uncomfortable truth about America’s politically inspired China bashing: It will backfire. If America fails to solve its saving problem – a reasonable scenario in light of fiscal gridlock and persistently subpar personal saving – the current-account deficit will persist. That means that any reductions in China’s share of America’s external imbalance would simply be shifted to other foreign producers. Significantly, this alternative sourcing will most likely have a higher cost base than Chinese production, thereby imposing the functional equivalent of a tax hike on already-beleaguered middle-class Americans.

As China rebalances toward a growth model that draws greater support from domestic demand, Washington should stop ranting about the renminbi and start focusing on the opportunities that this bonanza will create. That means emphasizing US companies’ access to China’s domestic goods and services markets. Pushing for a bilateral investment treaty that relaxes caps on foreign ownership in both countries would be an important step in that direction.

Similarly, the US needs to give China credit for having taken meaningful steps on the road to further currency reform. The mid-March widening of the daily renminbi-dollar trading bands to plus or minus 2% (from the earlier 1% band) is an important step in relaxing control over the so-called managed float. That, coupled with the 3% depreciation in the past few months, should send a strong signal to speculators that one-way renminbi bets are hazardous – a signal that could help dampen inflows of hot money, which have complicated liquidity management and fueled asset-market volatility in China.

There are two views of the future of the US-China economic relationship: one that sees only risk, and another that sees opportunity. Fixating on the renminbi falls into the former category: It misses the rebalancing and reforms already under way in China and deflects America’s focus from addressing its most serious long-term macroeconomic problem – a lack of saving.

By contrast, viewing China as an opportunity underscores the need for America to undertake its own rebalancing rebuilding US competitiveness and pushing for a meaningful share of China’s coming boom in domestic demand. Unfortunately, the revival in US saving that this will require is being drowned out by the renminbi rant.


Stephen S. Roach, former Chairman of Morgan Stanley Asia and the firm's chief economist, is a senior fellow at Yale University’s Jackson Institute of Global Affairs and a senior lecturer at Yale’s School of Management. He is the author of the new book Unbalanced: The Codependency of America and China.


A prolonged crisis in Ukraine spells trouble for all

Mohamed El-Erian

April 29, 2014



It is in everyone’s economic interest, both short and long-term, to solve the Ukrainian crisis; and therefore they will – or, at least, that is what rational thinking would suggest. But the reality is very different. And it is not necessarily because the parties involved in this crisis are irrational. Rather, it is because they are stuck in what game theorists call a “prisoners’ dilemma”. In the process, the risks of adverse global economic spillovers are on the rise.

The recent escalation of events in Ukraine has narrowed the set of options available to the four major parties involved – the country itself, Russia, central and western Europe and the US. As this occurs, the probability of each party attaining its desired outcome is rapidly declining, let alone them retaining sufficient control over developments on the ground. Indeed, the current course is one that leads to growing internal Ukrainian fragmentation, biting western sanctions on Russia, counter-sanctions by Moscow on western energy supplies, and a mounting financial bill for all.

The result would be economically and financially harmful to all, albeit to different degrees.
Ukraine would suffer the most, risking a deep economic implosion and full-blown financial crisis. In the process it would become even more highly dependent – and for many more years – on external financial assistance, and all the inevitable conditionality that comes with that.

Russia would experience a pronounced economic contraction coupled with high inflation, capital flight and a collapse in foreign direct investment. (Only on Friday Russia’s credit rating was cut to just one notch above junk level, and the central bank was forced to raise interest rates to counter capital outflows and currency pressures.) Moreover, depending on the severity and sector-focus of prospective western sanctionsspecifically, whether the financial sector is targetedRussia could also find it harder to make international debt payments and open trade letters of credit.

Assuming Russia retaliates by imposing its own sanctions – its most likely response to stiff western measures – the resulting disruption in oil supplies would tip western Europe into recession. With neither a healing US or a stabilising emerging world able to compensate fully, the global economy would most likely be tipped into a recession too.

Since it is both in the collective and individual economic interest of all to avoid such a combination of outcomes, it would be reasonable to expect that the major parties would come together to iterate to a better place. Moreover, they still have the means and time to do so. Yet based on the robust insights of game theory – the most instructive framework for analysing the current situation – the probability of this happening is declining, slowly approaching real uncomfortable levels.

Game theorists call this a “prisoners’ dilemma” – no single party can force an outcome on the others. But rather than pursue outcomes that are in the collective and individual interests, each party is forced by initial conditions to opt for suboptimal results relative to what is theoretically possible.

The reasons for this are essentially threefold: insufficient trust among the parties; inadequate infrastructure for enabling internal co-operation and follow-up enforcement; and the absence of a forceful outside party able to provide credible validation, assessment and process accountability. Only a major disruption dislodges the initial conditions that force the suboptimal outcomes.

Applied to today’s Ukraine, this approach points to a material increase in the tail risk of global economic contagion. Western central banks would, of course, do all they can to counter the negative economic repercussions if the damage was no longer contained within Ukraine. But they would struggle to counter a supply shock of that magnitude, particularly given the amount of policy ammunition they recovery from the global financial crisis.

There is still time for all parties involved have already used to help with the to realise what is at stake and return to serious negotiations. But the clock is getting closer to midnight; and conditions on the ground are getting harder to control. The more markets recognise this – as they have started to do – the greater the risk that they would also contribute to an accelerated déroulement that is in one’s short or long-term interest.


The writer is the former chief executive and co-chief investment officer of Pimco