Professor Maurice Obstfeld, University of California, Berkeley, delivered the twelfth L. K. Jha Memorial Lecture organised by the Reserve Bank on December 13, 2011 in Mumbai. The topic of his lecture was Gross Financial Flows, Global Imbalances, and Crises.
Governor Dr. D. Subbarao in his welcome address noted that Prof. Obstfeld, who is presently the Class of 1958 Professor of Economics and Director of the Center for International and Development Economic Research (CIDER) at University of California, Berkeley, has a truly enviable reputation as an academic in the area of international trade and finance, and as an adviser on economic policy making and practices. He is active as a Research Fellow of Centre for Economic Policy Research, a Research Associate at National Bureau of Economic Research and an International Research Fellow at the Kiel Institute of World Economics.
1. Introduction
In his speech, Prof. Obstfeld presented some useful lessons from current phase of prolonged global crisis that mostly emanated from the progress of financial globalisation. He pointed out that the global economic crisis of 2007-09 and the European sovereign debt crisis that followed have unleashed market forces that even policymakers in the mature economies were ill-prepared to counteract.
2. The Growth of Pure Asset-for-Asset International Trade
He documented the proliferation of gross international asset and liability positions and discussed some of the consequences for individual countries external adjustment processes and for global financial stability. He pointed out that, if a country has maximally hedged its idiosyncratic risk in world asset markets, its net international investment position (NIIP) will respond to shocks (including shocks to current and future world prices) in ways that cushion domestic consumption possibilities.
He mentioned that, in mid-1970s, the gross financial flows were considerably smaller than trade flows, but the former have grown over time and on average now are of comparable magnitude to trade flows. In the real world of financial trades, one agent viewing them as personally advantageous can work to the detriment of others implying that the sheer volume of financial trade can be positively correlated with financial instability risks.
3. Balance Sheet Vulnerabilities
Once a certain level of financial integration has been reached, gross position build-ups likely to imply a proliferation of counter-party obligations that may be defaulted and thus carry the risk of contagious financial instability through chains of leverage. In contrast, a countrys portfolio equity or FDI liabilities can fall quickly through the price mechanism without creating defaults. But there is only so much domestic capital for foreigners to hold, so beyond a point, increasing gross asset positions imply increasing associated default possibilities, with adverse implications for financial stability.
In the Indian context, external liabilities are heavily weighted toward equity, whereas external assets are heavily weighted toward debt-like assets (in no small measure consisting of non-gold official reserves). In the crisis year 2008, the values of externally-held Indian equities collapse, improving the NIIP sharply, but they recover in 2009-2010. These asset-price developments provide some natural insurance against economic shocks rather than provoking an external debt crisis.
4. Does the Current Account Matter Anymore?
With investment, the current accounts role is to allow investors to maintain globally diversified portfolios of equity claims through purchases of newly issued shares in the profits of capital. The foreign gross asset and liability positions offer the best picture of potential stability risks, and that hazardous gross positions can build up even in the absence of any net international capital flows.
Low interest rates due to global saving and investment patterns, along with accommodative monetary policy responses and other government policies, promoted credit and housing booms that themselves led to a further widening of the global imbalances. Financial competition, innovation, and arbitrage, proliferating within a lax regulatory environment, built a financially fragile superstructure of gross liabilities and claims on the back of those unsustainable booms. The big U.S. external deficit was a symptom of underlying destabilizing forces, and indeed enabled those forces to play out over an extended period.
A purely macroeconomic perspective also argues for the continuing importance of the current account as a component of aggregate demand. The emergence of a current account surplus in one region may depress aggregate demand globally, affecting global financial markets and eliciting policy responses in trade partners.
5. Conclusion
For several reasons, the current account still matters. The gross international asset and liability positions furnish the key conduit through which financial meltdown is transmitted and amplified. The national divergences between saving and investment not only remain key macro variables, they may well reflect financial developments with direct systemic implications.
The evolving world of financial globalization needs policy coordination assembling consolidated global information on financial activity, for regulating against macro risks, for providing liquidity support, and for resolving insolvent global financial institutions and governments.
Dr. Subir Gokarn, Deputy Governor, Reserve Bank of India highlighted the main messages of Prof. Obstfelds lecture and offered a vote of thanks.
Background
Shri Lakshmi Kant Jha was a many-sided personality who excelled in several walks of life. He was an eminent economist, a distinguished administrator, an able diplomat and a sage counsellor. He was Governor of the Reserve Bank of India during July1, 1967 to May 3, 21970. In recognition of his invaluable services to the nation and the Reserve Bank, the Reserve Bank of India has instituted a lecture series entitled as the L. K. Jha Memorial Lectures.
Ajit Prasad
Assistant General Manager
Press Release : 2011-2012/936
