Global imbalances: is sustainability nearly enough?

By Dr Sara Eugeni, August 2022

Dr Sara Eugeni examines the factors behind current account imbalances around the world. 

The unprecedented fiscal stimulus that took place in many advanced economies as a response to the pandemic has once again led to the widening of global current account imbalances, according to the International Monetary Fund’s (IMF) latest External Sector Report. Despite households’ savings having risen due to heightened economic uncertainty, this hasn’t compensated for the fall in public saving. As public debt has reached the highest level in several decades, advanced economies’ reliance on foreign borrowing has increased. The UK’s current account balance, for example, went from -3.1% of GDP in 2019 to -3.5% in 2020 and is projected to reach -3.9% in 2021.  

The global financial crisis of 2007-2008, and other crises around the world, taught us that large current account deficits are often a signal of economic distress. Excess levels of foreign borrowing can precede an economic crisis and/or can make economies vulnerable to sudden stops and reversals of capital flows.  

Nowadays, we’re in a much better place when it comes to evaluating the sustainability of a country’s external position. In 2012, the IMF introduced the External Balance Assessment framework aiming to assess external positions by comparing an economy’s actual current account balance with a current account norm. The current account norm is determined by estimating the level of current account that’s consistent with the country’s economic fundamentals. In case the actual current account is weaker or stronger than the norm, the IMF provides policy recommendations to reduce the current account gap. For example, if a country’s in deficit and the IMF estimates that the deficit should be smaller, this could signal that an economy’s receiving an excess of capital flows, e.g. for speculative reasons. 

My work has contributed to a line of research that identified demographic factors as being a key determinant of a country’s current account balance. My paper titled ‘An overlapping generations (OLG) model of global imbalances’ has been cited as one of the papers that led IMF researchers to rethink and update their methodology by including demographic variables in the estimation of the current account norm.  

The paper highlighted that one of the main reasons for the persistent current account imbalances between the US and China is that the latter lacks a comprehensive pay-as-you go pension system. Many Chinese citizens aren’t covered by a state pension and, when they are, the extent of the coverage varies across provinces. Chinese citizens then need to save more than Americans to fund their retirement. As domestic savings are much higher than what’s needed to fund domestic investment, this results in a current account surplus.  

I backed the importance of this mechanism with some empirical analysis showing that countries with a higher percentage of the working population covered by a pay-as-you-earn-system are more likely to have lower savings and current account balances. 

The inclusion of demographic variables into the IMF model is a welcome development, as the body of literature providing evidence that they’re important drivers of current account balances is growing. 

My analysis implies that at least part of the persistent current account deficits run by the US and other advanced economies over the past 30 years are sustainable. This is because they’re funded by a high level of savings in the world economy due to China’s different economic fundamentals.  

However, the IMF still recommends that China “shifts policy support toward strengthening social safety nets to reduce high household saving”. In fact, while sustainability is an important concept, the low real interest rates world in which we live in is an undesirable state of affairs. As Ben Bernanke claimed in 2005, the “global saving glut” has led to a decline in real interest rates around the world. Although China might be saving within the norm, my paper shows that policies that improve the Chinese pension system wouldn’t just reduce the imbalances but also ensure that people enjoy a higher standard of living through higher consumption.  

In another paper, I compare the current situation with the patterns of international borrowing and lending during the first wave of financial globalisation (1870-1914). At the time, the UK was in China’s shoes as the world economy’s main lender. However, differently to China, the UK received high interest payments on its foreign loans which allowed it to run a trade deficit by consuming more than it produced. An improved coverage to the Chinese pension would boost consumer spending, which could be beneficial for the world economy as a whole. However, as real interest rates would increase, the US and the UK would need to stop relying on cheap borrowing from China and live more off their own means by starting a potentially painful process of fiscal consolidation.  

More information on Dr Sara Eugeni's research interests.