Global economic imbalances must be addressed

The massive American current account deficit combined with the accumulation of foreign exchange reserves in Asia could pose a threat to the Canadian economy, according to the senior deputy governor of the Bank of Canada.

Speaking on Wednesday in Saint John, New Brunswick, Paul Jenkins noted that although world economic growth has been “remarkably strong” in recent years and that trend will likely continue through 2006 and 2007, several interconnected global trends will affect the Canadian economy.

“First, we have been witnessing large and growing global imbalances,” he said. “Most important for Canada, the United States is running a very large deficit on its external current account. The flip side of this deficit shows up primarily in Asia, where there are large current account surpluses and a massive accumulation of foreign exchange reserves.”

The U.S. current account deficit currently stands at $785 billion US, about 6.5% of the country’s GDP, Jenkins noted, adding that the level of U.S. indebtedness to the rest of the world has more than doubled over the past five years. “Asia has been the primary source of foreign savings flowing into the United States. Moreover, Asian countries have accumulated over $2 trillion US in foreign exchange reserves, with China alone holding $820 billion US at the end of 2005.”

These large imbalances are not sustainable over the long term, Jenkins warned. “No country, even one as big as the United States, can keep increasing its external indebtedness as a share of its GDP. Ultimately, these imbalances will have to be resolved.”

Part of the solution involves an increase in U.S. national savings, Jenkins said. “But higher U.S. savings means lower U.S. consumption, which would likely mean lower Canadian exports to the United States. To avoid the dampening effect that lower U.S. spending could have on overall global demand, other industrialized countries need to adopt policies that promote stronger domestic demand.”

Another potential roadblock involves Asian countries, particularly China, who continue to operate under a fixed or tightly managed exchange rate system. If those systems don’t become more flexible, Jenkins said, there is a risk that countries with floating exchange rates, like Canada, may have to bear more than their fair share of the burden of resolving the imbalances.

“There is also a risk that protectionist measures could be taken worldwide, hurting all trading nations, including Canada. For these reasons, the Bank of Canada has been on the side of the debate that advocates greater exchange rate flexibility for China and other Asian countries.”

In addition, the emergence of China and India as formidable global competitors means growing competition for Canadian products, both at home and in world markets, Jenkins said.

“For many firms and individuals, adapting to global change has been difficult and, in some cases, painful. All of us understand the challenges they face. Encouragingly, evidence from the bank’s quarterly surveys confirms that across Canada businesses have been responding to the new global economic realities,” he said.

While some firms have chosen to import more finished goods from lower-cost suppliers in Asia, others have moved away from products and markets with low profitability towards those that are likely to yield higher profit margins.

Filed by Doug Watt, Advisor.ca, doug.watt@advisor.rogers.com