Much like blood-letting that purportedly cures haemorrhagic fevers, to wit, the economic crisis has led to a relative "rebalancing" of hitherto existing global imbalances.

While "imbalances" is an imprecise word — at an intuitive level this means that the Americans are starting to save more, the excessive investments into the housing industry have fallen etc., In such an environment, one question that increasingly worries portfolio managers is what happens to savings, investments as the economy "recovers".

Will we go back to days when the party was raucous and the spirits were plentiful and imbalances reappear? To attempt to answer that question, it is important to have a semblance of precision.

One of the definitions of imbalances — proposed by Goldman Sachs — refers to the absolute sum of the current account balance. Current account is the difference between what a country saves and invests in.

Alternatively, current account can also be seen as the difference between what a country earns from the rest of the world and what it spends in the rest of the world. At its simplest, current account is the change in net foreign assets.
 
So, a country with a current account deficit ends up having declining foreign assets. However, the impact of current account balances on exchange rates has a uniquely schizoid interpretation.

Biases

Academics claim that there is at best a very weak causal relationship between the two. In contrast, markets (typically have a mercantilist zero-sum game view) operate on biases and barely-rigorous empirics — and view current account deficits as a precursor to depreciating exchange rates. In the period 2006-09 the American current account deficit declined from 6 per cent of US GDP to about 3 per cent.

This improvement in the deficit has emerged courtesy the decline in investment by about 19 per cent. Going forward, the personal savings rate is expected to increase to about 5.5 per cent by 2011. So, we have had a decline in investments and savings have slowly inched up.

The impact of this dual trend is that the current account deficit has declined. There are two schools of thought who differ about what is next. One, those who believe that as investment levels pick up again and as Chinese savings increase due to their stimulus plans — the American current deficit will spike up again.

Two, those who believe that American savings (especially as profit increases, the corporate savings rate) shall rise. While many analysts remain sceptical if the American consumer has fundamentally changed — in the ability to save — the underlying structural conditions have imposed some behavioural restraints. The possibility to borrow against home equity is increasingly difficult and so the generic savings levels will improve.

The flip side to this argument is that there is an increasing debate (between hedge fund manager Jim Chanos vs columnist Thomas Friedman (and Prince Al Waleed Bin Talal) about the credit-and-investment bubble in China.

Many, including Chanos, argue that a bubble is well underway in China due to over-investment. Their primary argument is that (a) China is cooking its statistics (most famously, car sales have purportedly increased, but fuel consumption has stayed flat!) (b) there is virtually no demand in all major sectors of production (c) the political leadership that calibrates the financial markets rewards inefficiencies. Yet, not withstanding their acute scepticism — it is hard to see a stunning collapse of China, as they envision.

Investments

In contrast, many have argued that China will continue to see increased investments. In fact, China needs increased investment to keep the capital-to-output ratio that sustains its 9-10 per cent growth.

Given the pernicious impact of asset depreciation, capital investments will only rise. In contrast, as income increases and credit markets improve in China, the decline in savings is also to be expected.

The result of this second view is that China's current account surplus will not spike and but rather gradually rebalance. What this means is that it is unlikely China will excessively supply its savings into the global economy.

So, in an explicit yet roundabout way, predictions on the American current deficit (and the dollar's fortunes) are correlated substantively with one's predictions on which way China is headed. And at the heart of it, increasingly, is the question if China is a zhi laohu — a paper tiger?

 

The columnist works for a major European investment bank in New York City. You can follow his tweets at: http://twitter.com/ks1729