The dependence of the global economy on the performance of the United States economy is not a new phenomenon, but United States deficits are much larger today than they were in the late 1990s. This is a matter for concern, since the high budget deficit of the United States will require fiscal adjustment and the unusually expansionary monetary policy stance may also need to be revised in light of inflationary pressures stemming from a surge in import prices and in particular from oil prices.
Geopolitical tensions and speculative forces explain much of the sharp rise in oil prices, which during the first half of 2004 reached their highest level since the early 1990s, but the rise has also been driven by the global recovery and rapidly rising demand from China. Substantially higher oil prices carry the risk of compromising growth in oil importing countries, especially those in the developing world that are facing serious balance of payments and external financing constraints while benefiting to a relatively small extent from potentially higher exports to oil exporting countries. Moreover, as in past episodes of rapidly rising oil prices, the oil exporting countries may not be able immediately to translate additional oil revenues into higher demand for goods produced in oil importing countries. Although higher oil prices have not had an immediate impact on inflation in the industrialized countries, such an effect cannot be ruled out should prices remain at current levels in the medium term. This in turn might lead to increase in interest rates.
Greater financial and exchange rate instability may also result from the fact that the United States is increasingly immersed in trade financial dynamics with East Asia. Expansionary fiscal and monetary policies in the United States have been providing a significant boost to exports from East Asia, including Japan, and are contributing to the large current account surpluses in the region. On the other hand, the East Asian developing countries have been following a policy of keeping their exchange rates at a competitive level following the currency depreciations in the late 1990s. This has required heavy intervention in the foreign exchange market, leading to fast reserve accumulation. As a result, East Asia has been recycling its current-account surpluses directly to the US, thereby financing a large part of the US current account and budget deficits through the investment of increasing foreign exchange reserves in United States Treasury securities. In 2003, East Asian developing countries, including China, bought more than $210 billion of foreign currency, compared to a United States budget deficit of $455 billion and a trade deficit of $490 billion. This pattern is unlikely to be sustainable in the long run, especially if pressure on the dollar to depreciate mounts as a results of further rising US deficits, which, in turn, could induce Asian central banks to minimize risks by diversifying their foreign exchange holdings into assets denominated I other currencies, in particular the euro.
Because of the recycling of balance-of-payments surpluses of the East Asian and a number of other developing and transition economies through an unprecedented increase in reserve accumulation in 2003, there has been a continued net capital outflow, in the order of $230 billion from developing and transition economies to the developed countries. This has occurred despite a substantial rise in the net inflow of private capital to the developing and transition economies, which has reached its highest level since 1997. On the other hand, although foreign direct investment (FDI) remains the most important type of private capital inflows to developing countries, it fell to its lowest level since 1996 as the wave of privatization, which had been a driving force behind FDI during the 1990s, leveled off. Conversely, credits and short term capital flows rose considerably, but the bulk of these flows were directed to a small number of emerging market economies, attracted by high interest rates or the expectation of currency appreciation. Indeed, a substantial proportion of private external financing did not flow to economies with external financing needs or low investment rates. Instead these flows were mainly directed to economies with often sizeable current account surpluses resulting from fast export expansion, adding to their foreign exchange reserves. This is another indication that capital markets cannot be counted on as a stable source of development finance.