Brazil, China, Commodities, Corporate Finance, Economics, Emerging Markets, Emerging markets, global economy, International Trade, Latin America, Long term finance, Uncategorized

Global Imbalances on the Rise

Capital Finance International, winter 2016-2017 

Discussions around large current account imbalances among systemically relevant economies as a direct threat to the stability of the global economy vanished in the aftermath of the global financial crisis. As the crisis originated in the U.S. financial system – followed by a second dip in the Eurozone – and global imbalances diminished in following years the issue has faded into the background.

More recently, some signs of a possible resurgence of rising imbalances have returned attention to the issue. We argue here that, while not a threat to global financial stability, the resurgence of these imbalances reveals a sub-par performance of the global economy in terms of foregone product and employment, i.e. a post-crisis global economic recovery below its potential. In addition, we approach how the re-orientation of the U.S. economic policy already announced by president-elect Trump suggests risks of new bouts of tension around global current account imbalances.

Are global imbalances rising again?

For five years now, the International Monetary Fund (IMF) has produced an annual report on the evolution of global external imbalances – current account surpluses and deficits – and the external positions – stocks of foreign assets minus liabilities – of 29 systemically significant economies. Results for 2015 have pointed out a moderate increase of global imbalances, after they had narrowed in the aftermath of the global financial crisis (GFC) and stabilized later (IMF, 2016a) – see Chart 1.

The evolution of imbalances in 2015 depicted in Chart 1 as explained by the IMF is reflective of three major drivers:

First, the recovery among advanced economies proceeded in an asymmetric fashion. Stronger recoveries in the U.S. and the U.K. relative to the euro area and Japan led to divergence in expected paths for monetary policies and appreciation of the dollar and sterling (pre-Brexit). The deficits of the U.S. and U.K. widened, together with increased surpluses in Japan and both debtor and creditor countries of the euro area (Chart 2).

Second, the fall of commodity prices – especially oil – transferred income from commodity exporters to importers. Overall however, it made only a moderate contribution to the narrowing of imbalances.

Third, prospects of monetary policy normalization in the U.S., as well as bouts of fears about the softness of China’s rebalancing, contributed to a slowdown of capital inflows and depreciation pressures in emerging markets (Canuto, 2016a).

All in all, larger U.S. deficits and augmented surpluses in Japan, the Euro area and China more than compensated for smaller surpluses in oil exporters and smaller deficits in deficit emerging markets and Euro area debtor countries. Hence, global current account imbalances widened last year, even if “moderately”.

However, a picture of higher global imbalances emerges if one focuses on the rising surpluses of two systemically relevant groups of economies. Chart 2 exhibits how in the euro area deficits in debtor countries have shrunk in tandem with the maintenance of surpluses in creditor countries (slightly increasing in the case of Germany). While the net foreign asset position (liabilities) of debtors has not diminished as much, their current account adjustment has added to the soaring surpluses the euro area as a whole runs with the rest of the world. Setser (2016) in turn has called attention to how the six major East Asian surplus economies – China, Japan, South Korea, Taiwan (China), Hong Kong (China), and Singapore – have reverted their post-GFC decline of surpluses and are currently topping even the euro area (Chart 3).

Such double trajectory of rising surpluses gives credence to those who have expressed concerns about a revival of rising current account imbalances as a source of risks to the global economy. While Eichengreen (2014) had declared “the era of global imbalances” to be over, more recently others believe they are “back” and claim that “rising global imbalances should be ringing alarm bells” (HSBC, according to Verma and Kawa (2016). To address this issue, however, it is worth first reviewing how the profile of current imbalances differs from the one prior to the GFC.

Global imbalances have evolved

The “era of global imbalances” up to the GFC (Chart 1) had two distinctive-yet-combined processes at its core:

On the one hand, credit-driven, asset bubble-led growth in the U.S., along with wealth effects, intensified the existing trend of domestic absorption (particularly consumption) growing faster than GDP. This resulted in falling personal saving rates and increasing current account deficits (Chart 4) (Canuto, 2009; 2010).

On the other hand, the accelerated structural transformation and rapid growth in China, led to high and rising savings and investments and producing ever larger current account surpluses (Chart 5) (Canuto, 2013a).

Two caveats about these distinctive-yet-combined processes are needed. First, the bilateral U.S. deficit with China in the period decreases by a third when measured in terms of value added,  as China became a “hub or a stroke” of value chains with intermediate stages supplied from abroad  (Canuto, 2013b). The U.S.-China bilateral imbalance therefore constituted outlets for production beyond China.

Second, while often linked as mirror images of each other – as in the hypothesis of an Asian “savings glut” causing low interest rates and asset price hikes in the U.S. (Bernanke, 2005) – the U.S. asset bubbles were more strongly associated to the “excess elasticity of the international monetary and financial system”, rather than to Asian current account surpluses (Borio and Disyatat,2011) (Borio, James, and Chin, 2014). Global current account imbalances cannot be blamed for the U.S.-originated GFC. As stressed by Eichengreen (2014):

“…the flows that mattered were not the net flows of capital from the rest of the world that financed America’s current-account deficit. Rather, they were the gross flows of finance from the US to Europe that allowed European banks to leverage their balance sheets, and the large, matching flows of money from European banks into toxic US subprime-linked securities.”

Asset bubbles in the U.S. to a large extent were blown by European banks through their balance sheets, by channeling U.S. money market funds into toxic assets. From the U.S.-Europe balance of payments standpoint, short-term outflows from the latter to the former were netted out by simultaneous long-term flows in the opposite direction. Close-to-zero net capital flows hid a lot of financial intermediation and asset-bubble blowing via banks’ balance sheets.

A parallel to that China-U.S. relationship can be traced within the euro area, including its later experience with a second dip of the GFC. The entry of the euro as a common currency was followed by a risk premium convergence toward German levels and to cross-border banking flows at extremely easy conditions. Consequent asset bubbles originated wealth effects and excess domestic absorption – besides inflated financial intermediation – in southern Europe and Ireland, leading to the subsequent debt crisis. The pattern of intra-euro area current account imbalances exhibited in Chart 2 was primarily a consequence of the euphoria taking place under conditions of “excess elasticity” of the euro area’s financial system.

The commodity super-cycle also helped shape global imbalances in this period seen in Chart 1. However, it was to a large extent a consequence of extraordinary global growth prior to the crisis, one in which commodity-intensive emerging market economies maintained growth trends above those of advanced economies (Canuto, 2010).

While such a pattern of global imbalances was unfolding prior to the GFC, much discussion took place about its potential to spark a crisis on its own when faced with a sudden stop. China’s current account surpluses were boosted by depreciated levels of the exchange rate sustained mainly by a piling up of foreign reserves. The same evolution was interpreted by some as an expression of a savings glut unmatched by enough domestic availability of safe-and-liquid assets like U.S. Treasuries.

Regardless of the emphasis of causality one might establish between export-led strategies and saving-glut-cum-safe-asset-scarcity, analysts were split into two camps, as described by Eichengreen (2014). Some analysts feared a possible crisis of confidence in the dollar bringing capital flows to a sudden halt, while others saw imbalances as an exchange of cheap Asian goods for safe and liquid U.S. assets. In the latter case, imbalances might gradually unwind as export-led strategies reached exhaustion and/or the desire for asset accumulation approached satiation.

In any case, the GFC happened before that dispute was settled and global imbalances started to unwind in its aftermath. U.S. personal saving rates began to climb, borrowers reduced leverage, the dollar devalued and the U.S. current account deficit shrank from almost 6% of GDP in 2006 to much lower levels from 2009 onwards. At the same time, as shown in Chart 5, China initiated its rebalancing from an exports and investment-led growth model towards higher domestic consumption and services, including an appreciation of the RMB and lower growth rate targets. This has not meant a straightforward change of trajectory, as caution against a post-GFC hard landing favored continued high investment in domestic housing and infrastructure as a component of the transition (Canuto, 2013a).

As we have already seen, deficits also diminished in the euro area in the aftermath of its debt crisis. The decline in commodity prices also helped global imbalances to shrink.

So, global imbalances did not spark a crisis and have returned in different configuration. Since current account balances are neither expected nor desired to be zero, how to make an assessment of whether the recent “moderate” uptick detected by the IMF might be a bad omen? Do those who have voiced concern over rising surpluses in East Asia and the euro area have a point? To answer these questions, it will be useful to look at the IMF exercise of judgement on whether global imbalances have been “in excess”, i.e. inconsistent with “fundamentals and desirable policies” (IMF, 2016a, Box 1).

How misaligned with fundamentals have current account imbalances been?

National economies are not expected to exhibit zero current-account balances and stocks of net foreign assets. At any period of time, domestic absorption – consumption and investment – can be larger or smaller than the local GDP, triggering inflows or outflows of capital, due to “fundamental” factors:

  • Differences in intertemporal preferences and age structures of their populations mean different ratios of domestic consumption to GDP;
  • Differences in opportunities for investment also tend to lead to capital flows;
  • Differences in institutional development levels, reserve currency statuses and other idiosyncratic features also generate capital flows and imbalances;
  • Cyclical factors – including fluctuations in commodity prices – may also cause transitory increases and declines in balances; and
  • Countries’ outstanding stocks of net foreign assets also have a counterpart in terms of service payments in their current accounts.

When global imbalances – and corresponding real effective exchange rates (REERs) – reflect such fundamentals, economies are in a better place than they would be in autarky (isolated with zero balances). There are situations, however, in which such imbalances may be gauged as in excess and countries should reduce them – as approached in Blanchard and Milesi-Ferretti (2010; 2011).

There is the straightforward case of imbalances being magnified by domestic distortions, the removal of which would directly benefit the economy. For instance, this is the case when deficits are higher because of lax financial regulation fueling unsustainable credit booms or excessively loose fiscal policies. It is also the case of surpluses that reflect extremely high private savings due to lack of social insurance or investments being curbed because of a lack of efficient financial intermediation. It is worth noticing that, while excessive deficits eventually face a shortage of external finance, surpluses suffer less automatic pressures to dissipate and can therefore persist for longer.

Furthermore, as pointed out by Blanchard and Milesi-Ferretti, there are also situations in which the multilateral interdependence of economies calls for restricting current-account deficits or surpluses. Unsustainable deficits of large, financially integrated economies are such a case, as a crisis associated to them may trigger cross-border effects.

Blanchard and Milesi-Ferretti additionally point out two conceivable situations in which surpluses can be deemed as in excess:

  • When current-account surpluses are the result of deliberate strategies of curbing domestic demand and deliberate exchange rate undervaluation, crowding out foreign competitors. On the other hand, given the simultaneous determination of savings and current account balances, it is always hard to disentangle such a strategy from other determinants of the current-account balance.
  • When an increase of one economy’s surplus takes place while others face difficulties to absorb it without suffering adverse, durable effects on their demand and output. This is the case when part of the world is caught in a “liquidity trap”, unable to resort to lowering domestic interest rates as an adjustment policy, or face obstacles to use countervailing fiscal policies.

The IMF “External Sector Report” aims to gauge to what extent current account balances and corresponding REERs are out of line with “fundamentals and desirable policies”, as well as whether stocks of net foreign assets are evolving within sustainable boundaries. What did the latest issue show?

Chart 6 displays its assessment of how intensively individual economies have exhibited current accounts – and REERs – that are out of line with their “fundamentals”, i.e. those features that would normally lead them to feature current account imbalances within certain estimated country-specific ranges. Stronger (weaker) corresponds to REER “undervaluation” (“overvaluation”). Stronger (weaker) also means that a current account balance is actually larger (smaller) than that “consistent with fundamentals and desirable policies” (IMF, 2016a, Box 1).

The report notices that the evolution toward less excess imbalances after the GFC has stopped and recent movements have given cause for concern (IMF, 2016a, p. 23):

First, those economies with external positions considered “substantially stronger” (Germany, Korea, Singapore) or “stronger” (Malaysia, Netherlands) have remained as such for the last 4 years. Also noticeable has been the shift toward stronger positions in the cases of Thailand and Japan.

Second, at the bottom of the distribution, while some countries reduced – or suppressed – degrees of “weakness” (Russia, Brazil, Indonesia, South Africa, and France), others remained (Spain, Turkey, United Kingdom) – with the addition of Saudi Arabia to this group after the oil price decline.

Third, on-going trends of current account imbalances are bound to lead to a further widening of some external stock imbalances accumulated since the GFC. While China’s external stock position is expected to stabilize, other large economies are projected to exacerbate their debtor (U.S., UK) and creditor (Japan, Germany, Netherlands) positions. Furthermore, the net foreign asset position of some euro-crisis countries remain highly negative despite years of flow adjustment with high unemployment and low growth.

In our view, although not giving ground to fears of a collapse in major financial flows, global imbalances have not gone away as an issue, as they reveal that the global economic recovery may have been sub-par because of asymmetric excess surpluses in some countries and output below potential in many others. The end of the “era of global imbalances” may have been called too early. Lord Keynes’ argument about the asymmetry of adjustments between deficit and surplus economies remains stronger than ever.

The IMF report has a point in calling for a “recalibration” of macroeconomic policies from demand-diverting to demand-supportive measures. This would be particularly the case for countries – or the Eurozone as a whole – currently able to resort to expansionary fiscal policies that have instead relied mainly on unconventional monetary policy – which has become increasingly ineffective at the margin. On the other hand, one must acknowledge that there are limits to which national fiscal policies can deliver cross-border demand-pull effects. Huge savings flows – like German or U.S. corporate profits – may also not be easy to redeploy.

Hence specific priority should be given to country-specific structural reforms addressing obstacles to growth and rebalancing. Which could be aided by cross-border dislocation of pools of savings currently parked in low-return assets. Paradoxically, global imbalances demand more globalization in a moment when the latter faces hurdles (Canuto, 2016b).

Implications of U.S. future trade and macroeconomic policies for global imbalances

Given the weight of the U.S. economy, global imbalances may undergo new shocks in the coming years as a result of the policy reorientation already announced by president-elect Donald Trump. Although at a preliminary stage, it is possible to devise two possible scenarios, the choice of which will depend on the options assumed by trade policies accompanying the macroeconomic reorientation.

President-elect Trump and his team have announced a macroeconomic platform with a likely strong potential impact: a major fiscal boost via infrastructure spending, corporate tax cuts, and a (financial and environmental) deregulation agenda (Canuto & Cavallari, 2016). Such platform underlies the announced goal of raising the U.S. economic growth to 4% a year, well above the potential 2% estimated by the IMF (IMF, 2016b).

Important details are yet to be filled out. For example, how much of the US$ 1 trillion of infrastructure investment pledged will be borne by the public sector or by public-private partnerships, and therefore how much of it will contribute to public sector deficits and debt. As suggested by different experiences around the world, including the United States, sudden increases in public investment are not easily implemented. The increase in investments in infrastructure will take some time to implement and there will be a lag in their effects, on both the demand and supply side.

Similarly, given that U.S. corporations currently display already high liquidity reserve buffers and low levels of acquisition of new fixed assets, the results of corporate tax reduction on their expenditures will depend significantly on the terms of conditions of local investment that may be attached. Such type of conditionality has already been alluded to in the case of profit repatriation.

There are also doubts as to the extent of the impacts of deregulation. In the case of finance, given the favorable climate in Congress and beyond to reforming the Dodd-Frank regulation, one can expect a relief from the regulatory burden that has been inhibiting bank credit in recent years. Environmental deregulation may also facilitate investment in the energy sector, particularly on shale oil and gas.

Assuming that, in fact, aggregate demand is stimulated, there remain doubts as to the current capacity of the response of domestic supply. After all, low rates of involuntary unemployment and upbeat levels of economic activity at the end of the Obama administration will be part of the latter’s legacy. In the event of binding supply limits, the macroeconomic effect will be largely directed to higher inflation and import growth. The frenetic appreciation of the dollar in the weeks following the initial announcements of Mr. Trump’s program reinforces the possibility of greater demand leaks via foreign purchases of goods and services.

In any case, a drastic change in the current regime of fiscal and monetary policies is likely to occur. The normalization of monetary policy by the Federal Reserve toward higher interest rates and smaller balance sheets tends to accelerate, while fiscal policy will definitely leave the consolidation path forced by Congress to the Obama administration in recent years. In effect, the U.S. is one of those cases in which the IMF – and others (Canuto, 2014) – have long advised a shift from monetary easing to expansionary fiscal policies. The appetite in the markets for Treasury bonds has been far from satiated and larger public deficits would be easily absorbed, for which it would suffice to issue signs of future reforms toward some smoothing of the public debt path.

It is in trade policy and in dealing with current account imbalances that two scenarios emerge: a “soft” scenario is the one in which the Trump government limits its campaign promises to occasional “arm twists” with corporations, like moral suasion and tax concessions in exchange for local investments or import substitution within value chains. The “hard” scenario would be to establish extraordinary tariffs and other restrictions on imports – China and Mexico were frequent targets of such threats during the election campaign.

In the “soft” scenario, there will be a demand stimulus for the rest of the world, albeit at the cost of greater current US imbalances which would not likely face financing difficulties. The “hard” scenario, in turn, contains high risks of substantial price increases in the domestic basket of goods and services, as well as of having a negative impact on the profitability of U.S. corporations. In addition, if followed by “trade wars” with countries directly affected, a “lose-lose” result in the global economy – as in the 1930s – could materialize (Canuto, 2016b). After all, the US economy nowadays has levels of trade and financial integration with the rest of the world sufficient to generate significant feedback loops.

Bottom line

Current account imbalances in the global economy have returned to the spotlight, albeit with a different configuration from the one that marked the trajectory prior to the global financial crisis. Not as a particular threat to global financial stability, but mainly because they reveal asymmetries in adjustment and post-crisis recovery between surplus and deficit economies and, in the coming years, for the risk of sparking waves of trade protectionism.

Otaviano Canuto is an Executive Director at the World Bank (WB). All opinions expressed here are his own and do not represent those of the institution or of those governments he represents at the WB Board.

Brazil, China, Commodities, Economics, Emerging Markets, Latin America, Uncategorized

Has the global trade-development link peaked?

Trade has been a key driver of global growth, income convergence, and poverty reduction. Both developing countries and emerging market economies have benefited from opportunities to transfer technology from abroad and to undergo domestic structural transformation via trade integration in the last decades. Yet, more recently, concerns have been raised over whether the current pace and direction of world trade lead towards a lesser development-boosting potential.

What happened to world trade? Is it cyclical or structural?

World trade suffered another disappointing year in 2015, experiencing a contraction in merchandise trade during the first half and only low growth during the second half. This follows a similar pattern since the onset of the global financial crisis (GFC), in which world trade volumes have lagged behind GDP growth (Figure 1).

Figure 1

World Real GDP and Trade Volume

(Annualized quarterly percentage change)

Has Trade-Dev Peaked-Fig 1.

Source: IMF, World Economic Outlook, October 2015.


Economists have indicated some circumstantial factors to explain this post-GFC pattern (Dadush, 2015) (Didier et, 2015, p.18). For instance, world GDP and trade figures would be reflecting the fact that the highly open-trade countries of the Eurozone have had a sub-par growth performance relative to the rest of the world. Furthermore, the  weak recovery of fixed investments in advanced economies – Canuto (2014a) – has suppressed an important source of trade volume, given the higher-than-average cross-border exchanges that characterize such goods.

More disputed hypotheses have also been argued. More stringent capital requirements and financial regulations might be curbing the availability of trade finance. Additionally, rising “murky” trade-restrictive tax-cum-subsidy policy measures adopted in some key sectors by some countries may also have become more significant than usually perceived (Global Trade Alert 18, 2015).

While those post-crisis factors have certainly played a role, some structural trends seem also to be at play. As suggested by Figure 2, after steadily increasing between the mid-1980s and the mid-2000s, the trade elasticity to GDP has lost steam (though it remains above one, thus implying that trade is still rising faster than GDP). After jumping in previous decades, the world’s exports-to-GDP ratio seems to have started to approach some plateau (or a “peak trade”). Since 2008, world trade has been rising slower than GDP at around 0.8:1, leading to a fall in the share of exports in global GDP. However, even if post-GFC factors were partially reversed, the presence of a long-term trajectory of trade elasticity displaying a slowdown already prior to the recent pattern would suggest no automatic return to the heyday.

Figure 2

Trade-income elasticity and Exports-GDP ratio – global economy

Has Trade-Dev Peaked-Fig 2.

Source: Escaith and Miroudot, ch. 7 in Hoekman (2015).

Notes: Merchandise exports only; world GDP and trade at constant 2005 prices; dollar figures for GDP are converted from domestic currencies using official exchange rates. Long-term elasticity is based on 10-year rolling period from 1960-1970 to 2005-2015 (2015 is based on forecasts).

Hoekman (2015) brings a thorough examination of both “cyclical” (post-GFC) and “structural” hypotheses about the global trade slowdown. Regardless of the weight attributed to these factors in explaining recent developments, three processes stand out as relevant for the purpose of analyzing what lies ahead in terms of the link between global trade and development. Two of them were “transitional” – in the sense that they were “one shot” – the unfolding of which occurred behind the extraordinary ascent of the global export-GDP ratio. The third one has evolved more gradually and will likely carry a significant transformative role ahead.

A major wave of vertical and spatial fragmentation of production has passed

The period from the mid-1980s to the mid-2000s was peculiar in several aspects. For one, these decades featured a process of economic reforms that aimed to remove barriers to trade, a multilateral trading system that reduced uncertainty for traders, and technological advances that reduced trade and communications costs. Combined, these trends ushered in years of sustained trade expansion. Average tariffs moved to well below ten percent, and in many countries a significant share of trade became duty-free. Advances in transport (such as containerized shipping) and information and communications technologies greatly reduced the cost of shipping goods and of managing complex production networks. Together these developments led to two major changes in the structure of global trade: (a) the vertical and spatial cross-border fragmentation of manufacturing into highly integrated “global production networks” or “global value chains” (GVCs); and (b) (to a lesser extent) the rise of services trade (Canuto, Dutz & Reis, ch. 3 in Canuto & Giugale, 2010) (Canuto, 2012).

The full establishment of cross-border GVCs intrinsically raises trade measured as gross flows of exports and imports relative to GDP, a value-added measure, because of “double counting” of the former – although the ratio of trade to GDP still increases even when trade is measured on a value-added basis (Canuto, 2013a). Given the then-prevailing technological state of arts in production processes, the policy and enabling-technology breakthroughs above mentioned sparked a powerful cycle of fragmentation, especially in manufacturing, with a corresponding cross-border spread of GVCs.

The re-shaping of the economic geography might have kept the pace with global trade impacts via further dislocation of fragments of GVCs, depending on the evolution of country locational attributes. Technological changes might also have altered optimal spatial configurations of the various manufacturing activities, as well as extended fragmentation to other sectors. This may well be the case ahead, as technologies and country policies keep evolving – some analysts point to a greater reliance on regional production networks, while others refer even to a potential reversal of GVCs because of 3D printing (“additive manufacturing”) (see references in the introduction of Hoekman (2015)).

However, the wave of cross-border manufacturing fragmentation of mid-1980s through the mid-2000s was particularly intense and time-concentrated (Canuto, 2015a). Figure 3 – from Constantinescu et al (2015) – shows that the ratio of foreign value added to domestic value added in world gross exports increased by 2.5 percentage points from 2005 to2012, after having risen by 8.4 percentage points from 1995 to 2005.

Figure 3

Ratio of Foreign Value Added to Domestic Value Added

in World Gross Exports (%)

Has Trade-Dev Peaked-Fig 3.

                                    Source: Constantinescu et al (2015)


A major wave of trade-cum-structural-transformation has passed – with China as a special case

The wave of fragmentation of manufacturing activity benefited from the incorporation of large swaths of lower-wage workers from Asia and Eastern Europe into the global market economy (Canuto, 2015a). Conversely, the former facilitated a process of growth-cum-structural-transformation with substantial total factor productivity increases in these countries via transfer of population from low-value, low-productivity activities to the production of modern tradable goods, for which foreign trade was instrumental – with China as a special case both in terms of speed and magnitude (Canuto, 2013b) ((Gautier et al, ch. 5 in Hockman (2015)).

The transitional nature of such a lift of world trade relative to world real GDP, even as the latter grew substantially, stemmed from the inevitable tendency of both starting to rise more in line once the intense transformation approached completion. Its extraordinary intensity also reflected a peculiar – and transitory – combination of ultra-high investments-to-GDP and trade-surplus-to-GDP ratios in China with large current-account deficits of the U.S. (Canuto, 2009).

More recently, China has initiated a rebalancing toward a new growth pattern, one in which domestic consumption is to rise relative to investments and exports, while a drive toward consolidating local insertion in GVCs to move up the ladder of value added is also to take place. That rebalancing has been pointed out as one of the factors behind the recent global trade slowdown, given China’s weight in the world economy and a recent trend of “import substitution” as illustrated in Figure 4.

Figure 4 

China’s Share of Imports of Parts and Components

in Exports of Merchandise

Has Trade-Dev Peaked-Fig 4.

                            Source: (Constantinescu et al, ch. 2 in Hoekman (2015)

Advanced countries are becoming services economies

While both the GVCs’ rise and growth-cum-structural-transformation – especially in China – were taking place, with corresponding impacts on the landscape of foreign trade, advanced – or mature market – economies maintained a steady evolution toward becoming services economies – a trend maintained after the GFC. Lower GDP shares of the value added in manufacturing have accompanied rising shares of employment in services (Figure 5).

Figure 5

Global manufacturing and employment in services

Has Trade-Dev Peaked-Fig 5.

                  Source: Institute of International Finance, “The rise of services – what it       means for the global economy”, December 15, 2015.

Both supply and demand factors explain such trends in advanced economies. On the supply side, beyond the higher pace of increases of productivity in manufacturing than in services (with correspondingly different rhythms of reduction in labor requisites), not only did the relative prices of manufactured goods fall, but a substantial part of local production was also off-shored as a result of GVCs and the incorporation of cheaper labor from areas previously out of the market economy world. On the demand side, one may point out both a higher income-elasticity of demand for services – reinforced by aging of the population – and to technology trends favoring “software” vis-à­-vis “hardware” – or “intangible” relative to “tangible” assets – as leading to an increasing weight of services in GDP and employment (IIF, 2015).

Those evolutionary features of supply and demand would also be valid for emerging market and developing countries – even if, as suggested in the upper half of Figure 5, they were partially mitigated in China and other Asia/Pacific countries by sucking manufacturing activities from other emerging market and developing economies. In any case, given the state of current technological trajectories, rising shares of services throughout would imply an anti-trade bias, given a still higher trade-propensity of manufacturing.

IIF (2015) goes as far as to argue that this has already brought consequences for the global business cycle, rendering it less influenced by swings in manufacturing output, with shock transmission from advanced economies increasingly taking place via trade of services among themselves and more weakly to manufacturing-dependent emerging market and developing economies. This would be one of the factors behind the abrupt decline of the world trade elasticity and of the recent decoupling of growth between recovering advanced and decelerating emerging economies.

Has the window of opportunity of developing via trade integration narrowed?

World trade may well live through a new era of rise relative to GDP (Hoekman’s introduction in Hoekman (2015)): on-going technological trajectories may deepen the fragmentation and increase the tradability of services; new vintage trade agreements – including possible TPP and TTIP (Canuto, 2015b) – are giving special attention to restrictions on trade of services. In fact, the content of services in current foreign trade transactions has already been higher than what gross trade figures display (Canuto, 2014b).

Another question is what lies ahead in terms of growth opportunities for non-advanced economies through foreign trade given the lines of evolution of the latter along the lines here described, one in which the factors that led to the “peak trade” seem to have exhausted. The nature and height of domestic policy challenges have changed substantially in a three-fold way:

First, China is in a league of its own and its rebalancing-cum-upgrading will condition other emerging market and developing economies. If it lets low-skill labor-intensive manufacturing activities go, a new wave of further GVC dislocations may open opportunities for countries currently endowed with cheap and abundant labor. On the other hand, its densification of local parts of GVCs will represent a competitive challenge to medium-range manufactures produced in other middle-income countries. The net result will also depend on the leakages outward of its domestic demand as it rebalances toward a more consumption- and service-oriented economy.

Second, the directions taken by technological trajectories and aggregate demand in advanced economies seem to point toward a broad alteration of the balance of locational advantages for production fragments, decreasing the weight of labor costs and augmenting the relevance of local availability of other complementary intangible assets. A “double whammy” on production and exports of non-advanced economies may take place: a partial reversal of off-shoring and a slower growth of outlets for their typical exports.

Third, the bar, in terms of what it takes to countervail that double whammy (improvements of the local business environment and transaction costs, quality of economic governance and other conditions favorable to accumulation of intangible assets) has been raised. Nonetheless, provided that such bar is reached, the local provision of – embodied or disembodied – services complementary to those produced or used in advanced economies may flourish. This will be the case, e.g. of natural resource-rich countries that manage to develop related intangible assets in terms of applied-science capabilities.

The run-up to “peak trade” was one of primarily exploring complementarities within GVCs to substitute for existing producers. The post-peak trade era may well be one of building complementarities.

* Written from my notes for a presentation at “The role of the US in the world economy”, OMFIF, Federal Reserve Bank of Atlanta, 12-13 November 2015.

Otaviano Canuto is the executive director at the Board of the International Monetary Fund (IMF) for Brazil, Cabo Verde, Dominican Republic, Ecuador, Guyana, Haiti, Nicaragua, Panama, Suriname, Timor Leste and Trinidad and Tobago. The views expressed here are his own and do not necessarily reflect those of the IMF or any of the governments he represents.

Dr. Canuto has previously served as vice president, executive director and senior adviser on BRICS economies at the World Bank, as well as vice president at the Inter-American Development Bank. He has also served at the Government of Brazil where he was state secretary for international affairs at the ministry of finance. He has also an extensive academic background, serving as professor of economics at the University of São Paulo and University of Campinas (UNICAMP) in Brazil.



Brazil, Corporate Finance, Emerging Markets, Emerging markets, Latin America, Long term finance

Latin American Corporate Finance: Is There a Dark Corner?


Since last year there has been much talk of possible financial stress stemming from increased debt leverage in non-financial corporates of emerging markets economies. A recent study has brought to light some key evidence on the Latin American case (Bastos et al, 2015).

Read here:

or here:

Best regards



My Articles in 2014 (with links)

Bear and bull dancing

Global Economy – Crisis Recovery and Secular stagnation Hypotheses

1. Macroeconomics and Stagnation – Keynesian-Schumpeterian Wars
Policy makers in the advanced economies at the core of the global financial crisis can make the claim that they prevented a new “Great Depression”. However, recovery since the outbreak of the crisis more than five years ago has been sluggish and feeble. Since these macroeconomic outcomes have to some extent been shaped by policy […]
May 6, 2014 | By Capital Finance International

2. Sluggish Postcrisis Growth: Policies, Secular Stagnation, and Outlook

(with Raj Nallari, and Breda Griffith)
Economic Premise n.139, April 2014.

3. Calibrating 2014
 Huffington Post – Posted January 2, 2014 | 12:35 PM
The global economy looks poised to display better growth performance in 2014. Leading indicators are pointing upward — or at least to stability — in major growth poles. However, for this to translate into reality policymakers will need to be nimble enough to calibrate responses to idiosyncratic challenges.

Emerging Markets

4. Liquidity Glut, Infrastructure Finance Drought and Development Banks
The world economy faces huge infrastructure financing needs that are not being matched on the supply side. Emerging market economies, in particular, have had to deal with international long-term private debt financing options that are less supportive of infrastructure finance. While unconventional monetary policies in advanced countries in the aftermath of the global financial crisis […]
September 19, 2014 | By Capital Finance International

5. Long-Term Finance in EMEs: Navigating between Risks and Policy Choices
(with Anderson Caputo Silva, and Catiana García-Kilroy)
Economic Premise n. 152, June 2014

6. China and Emerging Markets: Riding Wild Horses
Huffington Post Posted February 3, 2014 | 8:08 PM
One month ago, I discussed some major risks to a slight upturn in the global economic scenario for 2014. Among those risks, concerns with the growth slowdown and challenges with shadow banking in China have already come to the fore as the Chinese Year of the Horse approached…
Read Post

7. Sovereign Wealth Funds Are Coming Home
Huffington Post Posted January 15, 2014 | 5:30 PM
Followers of this blog have read several recent pieces on the changing landscape of investment finance in developing countries, particularly in natural resource-rich countries. We have approached the rise of development banks partially filling the void left by the retrenchment of international banking. We have also highlighted how…
Read Post

8. Commodity Super Cycle to Stick Around a Bit Longer
Some analysts have predicted that the commodity price boom has played itself out. However, natural resource-based commodity prices (with the exception of shale gas and its downward pressure on US natural gas prices) have remained relatively high over the last few years, despite the feeble global economic recovery (Canuto, 2014). The commodity price spike that […]
August 22, 2014 | By Capital Finance International


9. The High Density of Brazilian Production Chains
Huffington Post Posted November 13, 2014 | 12:50 PM
International trade has undergone a radical transformation in the past decades as production processes have fragmented along cross-border value chains. The Brazilian economy has remained on the fringes of this production revolution, maintaining a very high density of local supply chains. This article calls attention to the rising opportunity costs…
Read Post

10. Navigating Brazil’s Path to Growth
Huffington Post Posted November 9, 2014 | 10:01 PM
Brazil’s macroeconomic management will face four major immediate challenges in the near future. The response to them will be strengthened if we could have some indication of how to steer the Brazilian economy back to a growth route.
A first major challenge will be the upward realignment of domestic regulated…
Read Post

11. Three Perspectives on Brazilian Growth Pessimism
(with Philip Schellekens)
Economic Premise n.148, June 2014
It has become increasingly evident over the last two years that the growth engine of the Brazilian economy has run out of steam. Despite relative resilience during the global financial crisis and following a quick recovery, economic growth registered just 1 percent in 2012 and…

12. What’s Holding Back Brazil?

Project Syndicate,February 21, 2014

One often hears that Brazil’s economy is stuck in the “middle-income trap,” having failed to revive the structural transformation and per capita income growth that it enjoyed before the debt crisis…

13. Clogged Metropolitan Arteries
Huffington Post Posted February 10, 2014 | 3:45 PM
Bad conditions of mobility and accessibility to jobs and services in most metropolitan regions in developing countries are a key development issue. Besides the negative effects on the wellbeing of their populations associated with traffic congestion and time spent on transportation, the latter mean economic losses in terms of waste…

Middle-Income Trap

14. Access to Finance, Product Innovation and Middle-Income Traps
(with Pierre-Richard Agenor)
World Bank Policy Research Working Paper Series 6767, February 2014

15.  Access to Finance, Product Innovation, and Middle-Income Growth Traps

(with Pierre-Richard Agenor and Michael Jelenic)

Economic Premise n.137, March 2014.)

Debt Restructuring

16. Orderly Sovereign Debt Restructuring: Missing in Action! (And Likely To Remain So)
(with Brian Pinto and Mona Prasad)
The World Bank Research Observer 01/2014; 29:109-135.
(Accessible in and


Clogged Metropolitan Arteries

Bad conditions of mobility and accessibility to jobs and services in most metropolitan regions in developing countries are a key development issue. Besides the negative effects on the wellbeing of their populations associated with traffic congestion and time spent on transportation, the latter mean economic losses in terms of waste of human and material resources.

That led me to read with much interest a recent book – available on Google Play – on the impact of rail-based networks in São Paulo and Mumbai written by Jorge Rebelo, a transport specialist who worked for more than 25 years at the World Bank. São Paulo and Mumbai are both mega-metropolitan regions with about 20 million inhabitants and in dire need of quick solutions for better mobility and accessibility for their populations. As their population and income grew, auto and motorcycle ownership and their use also increased in both cities. Their mass transport systems are overloaded and traveling conditions are reaching their limit or are above their limit at peak-hours. Congestion is becoming unbearable in these two megacities and any new infrastructure requires relocation of houses and businesses, a very sensitive issue which in turn demands careful planning and heavy investment.

Both Mumbai and São Paulo metropolitan regions have extensive suburban railway networks dating from the 19th century that are now serving primarily a huge number of mostly low-income commuters every day. Built initially for transportation of freight and intercity passengers, these railways are now major commuter networks which are used by millions of passengers every day. According to Rebelo, both mega-metropolitan regions have delayed too long the substantial extension of their subways and other rail based systems either because of lack of coordination between levels of government and/or unreliable financing mechanisms which did not allow the required continuity to ensure annual additions to their rail based systems. The price for having procrastinated in facing those challenges has been huge!

Increasing challenges with mobility are of course not unique to those two mega-metropolises. Nineteen of the twenty-six largest metropolitan areas in the world are in non-advanced economies and most of them have suffered from a mismatch between, on the one hand, the fast dynamics of densification and transformation of space use and, on the other, the slower pace of institutional adaptation and/or investment finance to cope with the evolution of transportation needs. Mobility difficulties have become more intense even where population dynamics and rural-urban migration are not major factors, like in Russia, as approached by JungEun Oh and Kenneth Gwilliam in a recent World Bank review of the urban transport sector in the Russian Federation:

 “Russian cities are undergoing critical economic and social changes that affect the performance and condition of their urban transport systems. While the population of most large cities in Russia (over one million residents) has remained relatively unchanged over the last decade, the average income of the urban dwellers has sharply increased. The number of private cars per capita has increased rapidly, generating a demand for urban mobility which is increasingly difficult to meet.”

Through the long series of projects and analyses with which the World Bank has been supporting urban transport improvements in developing countries over the years – openly accessible on – one can notice how challenges associated with the mismatch between evolution of urban transport needs and institutional and investment finance responses are widespread in the developing world. One can also see how far ago those challenges had already become significant. For instance, a World Bank appraisal report on a project in Rio de Janeiro more than 20 years ago stated the following:

 “Urban Transportation is in a crisis in Brazil. Although the nation has invested heavily in the sector over the past 15 years, the effective demand for urban transport services particularly in major metropolitan regions (MRs), increased by about 82% in the last decade, and under present pricing policies, exceeds the existing peak hour supply in most MRs. To add to this capacity shortage, the Brazilian urban transport sector suffers from institutional problems due to a lack of coordination between the three levels of government responsible for urban transport in the MRs.

Not by chance, the issue of coordination between levels of government is highlighted in a set of policy proposals argued in Rebelo’s book – one that certainly serves as a reference for most metropolitan areas in developing countries. First and foremost, it is fundamental to establish some sort of real, effective Metropolitan Authority as a coordinator of long-term planning, evaluation and prioritization of new investments and coordination of their tariff and subsidy policy. This has also been pinpointed in a recent World Bank report – Institutional Labyrinth:

 “Typically, multiple agencies, at different levels of government, are involved in the management and delivery of urban transport infrastructure and services. More often than not, there is little or no coordination among them. This results in duplication and inefficiency in the use of resources and poor-quality services. The need for institutional coordination across space and function is increasingly being recognized as critical to developing an integrated and comprehensive urban transport system.”

The rapid transformation of space use and densification of connections between urban areas tends to turn previous transport- and urban-related political and administrative mandates obsolete and dysfunctional. Natural political inertia or resistance then often becomes a hindrance to building some sort of new, effective authority able to cope with the evolving metropolitan reality.

Some other recommendations follow in Rebelo’s book. For instance, there should be a search for financing mechanisms that are less dependent on floating government general budgets. A greater use of Public-Private Partnerships seems to be a trend in many parts of the world, and that might require operating subsidies. Therefore, financing mechanisms to guarantee the payment on time of those subsidies must be in place to avoid situations where concessions risk failing when operating subsidies are not paid on time. Revenues from advertising, use of station space, real estate developments around stations and urban operations can also be carefully planned.

Another key consideration is to strongly encourage the transparency of the bidding and evaluation process to foster international competitiveness and decrease costs. It also seems advisable to create an inventory of projects contained in the long-term strategy well beyond preliminary design stages. That would cut in the implementation schedule and make projects more attractive from a political standpoint. Finally, in most cases probably with the help of the judiciary, an effort must be made to find ways to simplify and accelerate expropriation/resettlement processes that may be deemed as necessary. All these recommended procedures require a definition of lines of authority appropriate to the evolving metropolitan reality.

The reality is some of the developing world’s transport infrastructures are beyond simple congestion; they are in danger of complete collapse or paralysis. There is reason to believe, however, that authorities in many countries have got the message and started to act more decisively. For instance, Mumbai just had its first monorail inaugurated and there are other rail and metro projects underway under the leadership of the Mumbai Metropolitan Region Development Authority. Sao Paulo and Rio are also undertaking substantial programs to try to address their mobility issues, and it’s high time they do it. Pay-offs from adjusting institutions and finance to the urban dynamics are clearly huge. It’s time to unclog the arteries of urban transport now to prevent stroke and paralysis tomorrow!

Follow the latest from Otaviano Canuto at


China and Emerging Markets: Riding Wild Horses

One month ago, I discussed some major risks to a slight upturn in the global economic scenario for 2014. Among those risks, concerns with the growth slowdown and challenges with shadow banking in China have already come to the fore as the Chinese Year of the Horse approached its inauguration last Friday.

Higher perceived risks about China have added another potential vulnerability, as witnessed by a new round of capital flows out from emerging markets in the last few weeks, resembling the one of last summer. While US 10-year Treasury yields have descended a bit since December, despite the beginning of the actual Fed tapering, news on China’s industrial production softness have sped up the on-going steady course of reduction of exposure of global portfolios to emerging markets in general, in favor of advanced economies. Idiosyncratic political and/or economic events also mattered in particular cases (Turkey, Ukraine, South Africa, and Argentina) but the fact that countries with liquid markets and less fluid conditions – like Mexico, Poland, and Malaysia – also suffered some asset sell-off indicates a much broader scope is at play.

How significant are the potential global spillovers from China’s economic growth slowdown? Why has the latest news particularly affected emerging markets? Last Friday, JPMorgan’s “Global Data Watch” offered some clues. Their research estimates that a 1 percentage point fall in Chinese GDP growth rates tends to have something like a total 0.46 p.p. negative impact on global growth, over four quarters, with effects through oil prices embedded. However, while this reflects a 0.21 p.p. drop in the GDP growth of advanced economies, the corresponding figure for the other emerging markets as a whole is 0.73 p.p. Commodity-dependent countries would be especially hard-hit, as the others may count on some revival of imports from advanced economies.

The world has kept close watch on the ongoing downward adjustment of China’s shadow banking system – credit intermediation involving entities and activities outside the regular banking system – with the near-default of a large trust product during the last few weeks being part of the worrisome news coming from the country. Not because of financial linkages with the rest of the world, as foreign ownership of entities is low and domestic sources and destinations of flows are overwhelmingly predominant, but for the risks that a disorderly unwinding might deepen the already expected growth slowdown.

The Chinese shadow banking system did not look very large compared to other countries (including other emerging markets) in the recent past – see Ghosh et al (2012). However, not only has the expansion  of the shadow banking system been extraordinary over the last three years, but also the private non-financial sector debt as a percentage of GDP, which has risen dramatically since 2009. China’s economic policy reaction to the post-2008 fears of a global crash led to some laxity with respect to the rapid expansion of shadow-banking channels of finance of investments and real-estate spending through special purpose vehicles, including those owned by subnational governments. As it often happens with sudden and intense spurts of credit ease, part of the pyramid of newly created assets and liabilities has “pyramids” or “white elephants” as their real-side counterpart.

Chinese authorities must therefore tread cautiously. While maintaining the pressure to correct balance sheets, by taking a hard stance on the side of official refinance backstops, they shall try to avoid panicky effects of occasional bankruptcies by ring-fencing some systemically relevant financial entities. How well this is done will bear consequences on Chinese current GDP growth rates, their impact on emerging markets in general and, therefore, on the risk that a panicky unwinding of exposure to emerging markets might provoke a strong deceleration of the latter, engendering in turn a negative feedback loop to advanced economies. The 2014 baseline for the global economy still appears to be trending upwards, but the Year of the Horse may be jumpy.

Follow the latest from Otaviano Canuto at


Calibrating 2014

The global economy looks poised to display better growth performance in 2014. Leading indicators are pointing upward – or at least to stability – in major growth poles. However, for this to translate into reality policymakers will need to be nimble enough to calibrate responses to idiosyncratic challenges.

Consider the United States. Job creation has accelerated since last August. Household debt is now US$800 billion less than at the end of 2008, due to liquidation or refinance at lower interest rates. The current housing recovery does not seem exhausted as demand is expected to outstrip the pipeline of housing starts this year. Non-financial corporations have plenty of cash, empowering them to respond to improved prospects. Finally, the agreement in Congress on the federal budget for 2014-15, together with the political weakening of the opposition to adjustments of the public debt ceiling, point to an easing of the fiscal drag that harmed the US recovery last year.

But even with these positive factors there is a challenge as the Federal Reserve starts unwinding  its “quantitative easing” (QE), beginning this month with a reduction of US$10 billion in its monthly asset purchases (currently at US$85 billion). Notwithstanding the limited size of this change – when matched with the US$2 trillion of assets currently held by the Fed – as well as Fed’s “forward guidance” signaling that basic interest rates will remain low for an extended period, the initially muted reaction in bond markets was followed by 10-year Treasury yields crossing the 3% mark at the end of 2013. As 2-year yields also climbed, markets seem to believe that the Fed will be obliged to speed up the unwinding. The Fed thus must be sure to strike the right balance of actions and communication so as to avoid precocious interest rate hikes which could harm the recovery.

In the Euro-area, perceived risks of a currency breakdown and a financial and economic collapse have receded substantially. Despite sticky high levels of unemployment in crisis-ridden countries, the European Central Bank (ECB) forecast of 1.1% (GDP growth) plus 1.1% (inflation) for 2014 has been taken as a signal that the bottom of the crisis has been left behind.

The crisis still casts some shadows, however. The implementation of structural reforms in several member countries has fallen short. The public and private debt legacy in those countries still remains tall. Furthermore, the Euro-area institutional framework, which has now been fully recognized as essential, has not yet been refurbished enough. While the time horizon for tackling these issues will necessarily be long, there is a major immediate task to be faced by policymakers: the health check and prescriptions to which their banks will be submitted this year.

The vicious circle between fiscal fragility and national banks’ balance-sheet deterioration that plagued crisis-ridden member countries has been broken, thanks to fiscal adjustment programs and, especially, the ECB’s promise “to do what it takes” to impede a collapse. Nevertheless, the resurgence of bank credit to the private sector – particularly to small and medium enterprises – will be fundamental to consolidate the recovery. Such resurgence will only take place when banks are once again able to be funded and create credit at interest rates much lower than currently available. Therefore the Euro-area major policy challenge will be to calibrate the “asset quality review”, stress tests, and new capital requirements making them tough enough to ensure that the exercise is credible, while simultaneously avoiding spooking markets.

China will also face the challenge of appropriately calibrating the implementation of its structural reform package. Higher penetration of non-state firms in several sectors, including the banking system, will require some slackening of regulation and phasing out interest-rate controls. Prior to that, however, the central government will need to rein in subnational finance and the “shadow banking” through which local governments have splurged on infrastructure and real estate spending in the last few years. Results from a public debt audit were released last month, showing that the debt of localities had risen 67% from the end of 2010 to June 2013.  In that context, another important consideration when looking ahead is to remember the interbank market turmoil of December, which only ended when the Central Bank of China conceded to providing liquidity.  This illustrated that authorities will have to step cautiously— a stone at a time— to cross the transition river, if an economic growth collapse is to be avoided.

Meanwhile, tax policy will be a key policy challenge in the case of Japan. Aggressive fiscal and monetary stimuli implemented during Prime Minister Abe’s government have jolted Japan’s economy out of its deflationary lethargy.  However, Japan’s public debt has climbed to levels around 250% of GDP. As part of the solution, the consumption tax will be hiked to 8% from 5% in April. There is also a scheduled decision in next November on whether to additionally increase it to 10% as of October 2015. It will be crucial that such a higher tax burden does not countervail the overall anti-deflationary direction of macroeconomic policy.

Finally, there is the case of emerging economies coping with the actual unwinding of QE. Last summer – in between Ben Bernanke’s testimony to the US Congress in May, when he alluded to the eventual unwinding of the currently third round of QE, and the Fed meeting in September postponing its beginning – the so-called “fragile 5” (Brazil, India, Turkey, Indonesia, and South Africa) underwent massive capital outflows and large currency depreciation. Some analysts referred to that turmoil as a potential revival of the emerging-market crises of the 1990s. Those countries shared in common the presence of large, liquid, and integrated financial systems, as well as current-account deficits associated with substantial capital inflows and currency appreciation since the beginning of the US “unconventional monetary policies.”

Now that the unwinding is really starting, the baseline scenario is not one of a repetition of the turbulence, since changes in asset values, exchange rates, and investors’ positions have not reverted. The unwinding is to some degree already priced in. On the other hand, four of the “fragile 5” (Brazil, India, Turkey, and Indonesia) will have major elections in 2014. As they still remain vulnerable to sudden stops in capital flows, their macroeconomic performance will depend on the calibration of their macroeconomic policies and on political risks.

The bottom line is this: there is room for optimism about the global economy in 2014. The key is to temper this with caution given that the success of the global economy will hinge on policymakers’ ability to strike the right balance in several key parts of the world.

Otaviano Canuto is Senior Adviser and a former Vice-President of the World Bank Group.

(Posted on Huffington Post, Roubini Global Economics, Seeking Alpha, and Growth and Crisis blog – World Bank)