TIPPING THE SCALES ON GLOBAL REBALANCING / THE FINANCIAL TIMES ( VERY HIGHLY RECOMMENDED READING )

Tipping the scales on global rebalancing

By John Plender

Published: February 2 2010 15:05

Before 2007 the savings that poured out of current account surplus countries in Asia and northern Europe were relatively insensitive to risk. In effect, the world’s bond market vigilantes threw in the towel as the weight of money generated by the savings glut put uniform downward pressure on investment yields. Come the financial crisis, those same savings became indiscriminately risk averse as markets crashed. Then last year, they chased risk assets pretty indiscriminately once again.

But not any more. The travails of Greece last week showed that bond vigilantes are not only back but discriminating with a vengeance. Among the most powerful is Bill Gross of the Pimco fund management group. In his latest investment outlook he did his spectacular best to turn the UK into a bond market outcast when he declared that the gilt market rested on a bed of nitroglycerine.

This renewed differentiation in the markets seems unlikely to do much damage to the US, which borrows in its own currency and will continue to be the inescapable repository for China’s official reserves as long as the renminbi remains pegged to the dollar at a super-competitive rate. Even Japan, with a horrific overhang of public sector debt after years of stagnation, may be relatively safe because most of the debt is owed to the Japanese themselves.

If there is room for a financial domino theory, the place for it is Europe. For Greece is not the only country with problems. In essence, the eurozone has a structural flaw in the shape of a north-south financial imbalance. The super-competitive surplus savers of northern Europe are dependent on the Club Med countries to absorb their exports. The Mediterraneans suffer from fiscal strains and competitiveness problems that cannot be solved by devaluation. Yet the Protestant northerners are reluctant to rebalance their economies towards domestic consumption to address this.

The risk is that what started in Greece, with the worst southern European budget deficit and a history of playing games with official numbers, could ultimately reach Portugal, then Spain and finally Italy.

As for the UK, the public sector debt ought to be manageable. With currency freedom and relatively flexible markets, the British economy should rebalance more quickly than troubled eurozone economies. Yet currency flexibility is a deterrent to bond investors when public finances are overstretched. Nor has sterling the inherent support enjoyed by the US or the eurozone countries.

Worse, with an election looming, no politician dares talk honestly about fiscal intentions, so markets and rating agencies tend to assume the worst case scenario. It then takes very little careless talk in the political debate to activate the explosive qualities of nitroglycerine. Mr Gross may thus prove all too prescient. He urges bond investors to look to high growth countries with trade surpluses and savings-oriented economies, as in the better emerging market countries. He is also attracted by developed world fiscal conservatives such as Germany and Canada.

Many in the markets share this view about the global post-crisis winners and losers, arguing that there has been an ineluctable economic power shift to Asia. In the short run this intuitively makes sense. Yet in the longer run the pecking order could be more problematic since the world’s biggest surplus countries – Japan, China and Germany – appear to have no appetite for structural reform to shift away from export led growth.

That sets the stage for more trade friction. And Lawrence Summers, President Obama’s chief economic adviser, was indeed musing noisily in Davos about the theoretical justifications for protectionism in response to endemic excess capacity and mercantilist policies. He made no mention of China’s exchange rate peg because he did not need to.

Americans may well be tempted by the thought that protectionism could shock surplus savers into structural reform. Yet these countries have just had a huge shock because their slow response to the crisis meant they were savaged by the collapse of world trade. Their mindset nonetheless appears to remain unchanged, so the risk of deficient global demand has not gone away. When that last happened in the 1930s, the biggest surplus country was the US, which suffered a far greater loss of output than such deficit countries as the UK.

The harsh reality is that the economic power shift to Asia is conditional on the maintenance of an open trading system. As long as Asian countries continue to save vastly more than they invest, that assumption cannot be taken for granted. Those contemplating joining the financial brain drain to the region should remember that export dependency and a structural lack of domestic demand are potentially catastrophic in a protectionist environment.

John Plender is an FT columnist

Copyright The Financial Times Limited 2010.