–For China, External Demand In Part Reflected ‘Artificially’ Low FX

By Steven K. Beckner

ATLANTA (MNI) – Federal Reserve Vice Chairman Donald Kohn said
Tuesday that the increase in the U.S. savings rate since the financial
crisis is apt to endure and help reduce the U.S. current account
deficit.

On the other hand, business investment may outpace business profits
and savings, working in the opposite direction, Kohn said in remarks
prepared for a conference on the international monetary system sponsored
by the Swiss National Bank and the International Monetary Fund in
Zurich, Switzerland.

Kohn, who is retiring next month, said the U.S. must increase
savings and rely less on debt-financed consumption. It also needs to
increase exports, and national savings will need to be increased by
reducing deficit financing, he said.

Meanwhile, he said other countries must rely less on exports to
fuel growth and increase the flexibility of their exchange rate regimes.

Kohn said current account deficits did not cause the financial
crisis, as some have alleged, but said they did “enable” the crisis to
develop.

He said “the main causes of the crisis originated in the financial
sector and stemmed from a widespread underappreciation and underpricing
of risk.”

“Failures of risk-management systems, incentive problems in
securitization and compensation structures, and regulatory shortcomings
and gaps led to a vulnerable, overleveraged financial system with
inadequate capital and liquidity buffers,” he continued.

“These problems were amplified by the eagerness of U.S. households
to take on huge amounts of mortgage debt and of lenders to advance them
the credit, justified by overly optimistic expectations for house price
appreciation as the real estate boom progressed,” he said.

But Kohn said “these financial sector problems were enabled, if not
encouraged, by developments in the global economy.”

“The capital outflows associated with the persistent current
account surpluses were large even in net terms and, combined with
relatively restrained business capital spending in many advanced
economies (including the United States), put downward pressure on real
interest rates globally,” he said.

Kohn said “there is no compelling reason to believe that low real
interest rates, by themselves, pose a particular risk to global economic
and financial stability, as real interest rates should be driven by
underlying forces to balance the global demand for saving and
investment.”

He said “capital inflows from abroad can be beneficial if they are
invested prudently. But in an environment in which the financial sector
is prone to excess and the supervisory structure does not respond
sufficiently, the interaction of low interest rates and financial
vulnerabilities can clearly be dangerous.”

Looking ahead, Kohn said “a more sustainable and balanced global
economy in which the pattern of current account deficits and surpluses
is more clearly determined by the efficient allocation of capital across
borders is necessary to reduce the risks of future crises.”

He said “achieving better balance will require lasting shifts in
spending, production, saving, and borrowing around the world.”

“The U.S. economy will need to be less driven by consumption and
housing and will need to rely less on debt to finance spending on
consumption and housing,” he said. “And exports and capital investment
will need to play a larger role in the economy.”

Kohn said that “to some degree, this rebalancing is already
happening.” He noted that the U.S. current account deficit fell to 3% of
GDP last year from a pre-crisis peak of 6%.

And Kohn predicted, “This higher saving rate should prove
reasonably durable as households seek to pay down debt and rebuild
wealth, and no longer count on house price appreciation as a substitute
for saving out of current income.”

“In contrast, the pickup in business investment as the economic
recovery strengthens could well outpace any increase in business profits
and saving, and part of the narrowing in the current account deficit
could be reversed, absent other developments,” he said.

Echoing recent comments by Fed Chairman Ben Bernanke and others,
Kohn said “one of the steps to achieve rebalancing must be placing U.S.
fiscal policy on a more sustainable path.” He estimated that gross
dissaving by the government sector represents about 6.75% of U.S. GDP.

Meanwhile, “countries that have become accustomed to running large
current account surpluses must learn to rely less on external demand and
more on their own domestic demand,” he said, adding that “for some
economies, a rebalancing of demand toward domestic sectors will require
significant changes in relative prices, and hence more flexible exchange
rates will need to be part of the equation.”

In the past, for China and other nations, “economic growth heavily
depended on external demand, in part reflecting policies to keep
exchange rates artificially low through intervention in currency
markets,” he said.

The measures he recommended “will not preclude the emergence of
large current account surpluses and deficits in the future,” but would
make them less worrisome.

“What is important is to ensure that international capital flows do
not combine with other weaknesses in the financial system to lay the
groundwork for some future global crisis,” he said. “Consequently, we
need to work simultaneously on rebalancing global demand and
strengthening the structure, operation, and governance of financial
systems.”

** Market News International Washington Bureau: 202-371-2121 **

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