The risks of international imbalances: beyond current accounts

26 June 2011

Global current account imbalances are still with us, bringing the prospect of disorderly exchange rate adjustments and protectionism. But the imbalances extend beyond current accounts to gross financial flows, which today dwarf the net movements commonly associated with the current account. And they pose perhaps even bigger risks by giving rise to potential financial mismatches and facilitating the transmission of shocks across borders. Not only that, but cross-border financing makes rapid credit growth possible even in the absence of domestic financing. As the experience of the past few years reminded us, a reversal of strong cross-border capital flows can inflict damage on financial systems and ultimately on the real economy.

The imbalances in current accounts and in gross financial flows are related and need to be addressed together. Sound macroeconomic policies will play a key role in this regard, as will structural domestic policies to encourage saving in deficit countries and encourage consumption in surplus countries. Although the adjustment of real exchange rates is also required, it will not, by itself, be enough. Countries will need to implement policies that strengthen prudential frameworks and the financial infrastructure. Capital controls, best left as a last resort, can offer only temporary relief.

While adjustment by surplus and deficit countries is necessary and mutually beneficial, it is constrained by a fundamental problem: countries may find unilateral adjustment too costly. This means that international coordination is essential to break the policy gridlock.