April 2016
Michael Craig, CFA
Vice President & Director
TD Asset Management Inc.
Amol Sodhi, CFA
Vice President
TD Asset Management Inc.
Haining Zha, CFA
Vice President
TD Asset Management Inc.
The Imbalance Game
Stumbling from one crisis to the next
Are the long-term viability of the Euro, a perpetual Japanese quantitative easing program
and sluggish U.S. growth all related? Are they independent issues or all manifestations of
the same underlying problem?
While not trying to predict the next crisis, we outline a framework of imbalances that
helps to better understand the structural challenges ahead of us. With this framework
in mind, investors can be better positioned to navigate the current and future investing
environment, with the ultimate goal of protecting capital and taking advantage of the
opportunities when they do occur.
Looking beyond traditional theory
When analyzing the behavior of economies and markets, people often focus on cyclical
booms and recessions. This is understandable, as this is what has mattered most in the
past. However, we have to be aware that there is a lot more at play than just economic
cycles, particularly in today’s environment.
At this juncture, there are many long term headwinds ahead of us, one of them being
the peak of a debt super cycle. In the last 30 years, debt has been accumulating at a
phenomenal pace in both developed and emerging economies. It has been the
formula that created secular prosperity. But since the 2008/2009 global financial crisis,
the world has felt debt fatigue and the real danger of secular stagnation. Even with
extremely low interest rates and increasingly unconventional monetary policy, the world
still struggles to find solid economic growth.
Within this paper, we will delve into the crux of today’s economic challenges and analyze
how this debt super cycle has been created and what investors can expect going forward.
TD Asset Management | The Imbalance Game
2
Policy Distortions —
The global economy’s Achilles Heel
role free floating exchange rates serve. There are two primary
benefits to global trade:
The root cause of many of the issues that plague the global
economy can be found in policy distortions. In our research, we
categorize policy distortions into two types: Foreign exchange
distortion and government and fiscal policy distortion.
Policy Distortions
Foreign
exchange
External
imbalance
Government
and fiscal policy
Find more
aggregate
demand
Internal
imbalance
1. Comparative advantage: leads to greater number of
goods per available resources.
2. Specialization: leads to greater innovation and higher
quality of goods.
Free-floating exchange rates help to ensure that trade and
currency values remain balanced with one another and prevent
material economic imbalances from building.
To illustrate the relationship between foreign exchange and
trade, we use the chart below. Using foreign exchange as the
horizontal axis and current account balance as the vertical axis,
we can divide global economies into 4 quadrants. In the middle,
is a stable trade zone, where the deviation from fair value
exchange rates is relatively small and current account surplus/
deficit relatively insignificant. Most countries tend to gravitate
towards the stable trade zone over time.
Current account
Surplus
Foreign exchange distortion refers to when a country’s currency
is kept persistently below or above its fair value. Government
and fiscal policy distortion refers to a variety of inappropriate
policies chosen by governments, and can be very country
specific. For example, in Greece, government and fiscal
policy distortion could mean excessive government spending,
inadequate tax collection measures and an overly generous
pension benefit, however, for China, it could mean a weak social
safety net that hinders consumer spending and the excessive
leverage taken on by state owned enterprises.
These two types of distortions, in turn, cause two types of
economic imbalances. On one hand, foreign exchange distortion
causes an external imbalance which is reflected as persistent
current account surplus or deficit and unusual capital flow
patterns. On the other hand, government and fiscal policy
distortion leads to an internal imbalance, which can take many
different forms, but typically ends up as some form of debt within
domestic sectors, e.g. dangerously high government debt in Japan
or increasing income inequality and household debt in the U.S.
pre financial crisis. These policy distortions allow the two types of
economic imbalances to build without proper adjustment.
Over the next few sections, we will elaborate on each of the
two policy distortions and the imbalances they cause. Then we
will bring the two concepts together to show that they are two
sides of the same coin, reinforcing each other to precipitate debt
accumulation.
Foreign exchange distortion and
external imbalances
Before addressing foreign exchange distortion, it is helpful
to first clarify why countries trade in the first place and what
Capital
misallocation
Productivity
and innovation
China
Foreign
exchange
Switzerland
Stable trade
Optimal location for
most countries
Depreciation
Appreciation
India
Greece
Importing capital
and investing
Consumption binge
For illustrative purposes only. Point in time examples.
Deficit
The top right quadrant represents countries with higher
productivity and are internationally competitive, e.g. Switzerland.
Free floating exchange rates reward these countries with stronger
currencies and greater purchasing power. This stronger currency,
in turn, can make the nation’s goods more expensive for trading
partners to purchase and can eventually reign in their exports
growth, leading to a smaller current account surplus. If the
country is not able to continue to innovate and generate large
productivity gains, it will be pulled back to the stable trade zone.
The opposite case is the bottom left quadrant. This quadrant
includes countries that have lower productivity and cannot
produce at a competitive price on the international market, e.g.
India. Households are punished with a cheaper currency and
TD Asset Management | The Imbalance Game
weaker purchasing power, which results in a lower standard
of living. However, because of the cheaper currency, it becomes
more attractive for investment. With enough investment in
infrastructure and other key factors of production, the countries
within this quadrant can have greater productivity and output
growth, moving to the upper right towards the stable trade zone
and have smaller current account deficits over time.
In normal circumstances, countries will move back and forth
between the top right and bottom left quadrants and gravitate
towards the center stable trade zone. That simply reflects the
way foreign exchange rates function properly and regulate trade.
However, foreign exchange distortion compromises the natural
rebalancing mechanism and places some economies into the top
left and bottom right quadrants.
The top left quadrant is for countries with persistent surpluses
and undervalued currencies. China before 2008 is a good
example. China had a hard currency peg to the U.S. dollar
up until July 2005 and only gradually appreciated its currency
thereafter with a soft peg. This led to massive exports and
current account surpluses, which peaked at 10% of its GDP.
Countries in this quadrant will keep accumulating capital
which typically leads to capital misallocation.
Possible reactions to
foreign exchange manipulation
Countries not engaging in currency manipulation can
counter the actions of their trading partners’ with three
distinct responses:
§§ Constructive measures.
Simply outcompete by raising their potential growth
level. Investing in total factor productivity and
reducing cost structures can accomplish this. This
can also be accomplished through research and
development which ultimately creates wealth. An
example would be the post-World War II to the late
1960s period in the U.S.
§§
§§
Enact protectionist measures. Tariffs and duties are
applied to goods produced by the offending country.
This in turn prevents imbalances from growing larger
but severely cripples global trade. An example would
be the trade policies of the 1930s.
No measures taken. Here countries are
accumulating persistent trade deficits and are
faced with trading partners who have an unfair
advantage in foreign exchange rate. This in essence
is like perpetually consuming and paying for this
consumption by simply issuing IOUs. The longterm implications are lower potential growth as
it depletes future demand while consumption
borrowing crowds out investment.
3
The mirror image of that is the consumption binge case in
the bottom right quadrant. This quadrant is for countries with
persistent current account deficits but not any meaningful
currency depreciation. Greece before the sovereign debt crisis
is a good example. It had persistent trade deficits, however, its
currency was not adjusting because the strength of the other
European countries supported a stronger Euro. A stable currency
enabled it to keep borrowing to consume.
Government and Fiscal Policy Distortion and
Internal Imbalances
The second policy distortion that can create internal imbalances
and significantly suppress growth is government and fiscal policy
distortion. Two common examples of such policies include:
1. Excessive government spending
2. Inappropriate tax and social policy
Excessive government spending leads to higher debt, which has
a detrimental effect on future economic growth. In essence,
taking on additional debt does not create new sustainable
aggregate demand. It merely exhausts future demand. When the
debt burden reaches unsustainable levels, the country becomes
vulnerable to a debt spiral —
­ particularly after an external shock.
Furthermore, inefficiency in government spending tends to lead
to much lower long term productivity growth.
Inappropriate tax and social policy is often less obvious. Income
and wealth inequality issues are normally categorized as social
rather than economic issues, falling off the market’s radar. But
we believe it has deep ties to the macroeconomic phenomenon
we observed. One of the most prominent phenomena in
macroeconomics has been the decline of labor’s share of
income globally over the past 20 years.
Why is this important? In most developed economies, growth
is driven by consumption. Household consumption, in particular,
depends on three factors: income, wealth and credit (borrowing).
When income inequality increases and labor’s share of income
drops, less money can be recycled into consumption for the
average household, creating a lack of aggregate demand.
For the wealth factor, wealth inequality is even more severe
than income inequality.
According to academic research1, the share of wealth owned
by the bottom 90% of the population has been steadily
decreasing in the past two decades and currently only stands
at 20% of the total wealth. Therefore, solid consumption
growth requires more contribution from the wealthy group.
However, that is not the case in today’s economy. Research
shows that individuals in the wealthy group tend to save more
and consume relatively less. The top 1% wealth bracket has
a saving rate close to 40% compared to close to 0% for the
bottom 90%.
TD Asset Management | The Imbalance Game
4
On the other side, a more severe internal imbalance means more
spending, higher trade deficits and a need to borrow more. This
exacerbates the external imbalances.
The wealthy are saving more and,
relatively, consuming less
Saving rates by wealth class
50%
Top 1%
40%
30%
Top 10 - 1%
20%
10%
Bottom 90%
0%
-10%
-20%
This reinforcing cycle can continue because both exporting
and importing countries have found more aggregate demand.
From the exporting country’s perspective, it has extracted
more demand from net exports. From the importing country’s
perspective, it has found more demand through borrowing
and consumption. Within a period of time, growth in both
countries would look deceptively robust and both countries
have motivation to keep the cycle going until it becomes
unsustainable. The fundamental problem is that borrowing and
capacity expansion cannot go on forever.
Is the future bleak?
1910s 1920s 1930s 1940s 1950s 1960s 1970s 1980s 1990s 2000s 2010s
Source: Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax
data, Emmanuel Saez, Gabriel Zucman, National Bureau of Economic Research
Consequently, the burden of growth naturally falls on the third
factor: credit/borrowing. But as we know, relying on credit is
never sustainable and can eventually lead to a credit bubble and
financial crisis.
Linking External and Internal Distortions
The two types of economic imbalances created by policy
distortions do not exist in isolation. They tend to feed and
reinforce each other. The linkage between external and internal
imbalance is through the Balance of Payment relationship.
When a country suffers from an external imbalance and has
a persistent current account deficit, it essentially borrows
from international capital markets and has a capital account
surplus. This borrowing is financing the internal imbalance, be it
government, corporate or consumer debt. The availability of the
funding also keeps interest rates low and spurs more borrowing,
making the internal imbalance even worse.
One of the most important conclusions from our research
is that the two types of policy distortions create economic
imbalances that can ultimately destroy growth potential. We
believe they create unsustainable growth in the early stages
and give the appearance that economies are strong and robust.
However, when this process eventually ends, there is no V-shape
recovery. They will start impeding growth in later years as the
slow process of deleveraging takes hold. We are simply at the
beginning of this latter stage.
So is the future bleak? Not necessarily, but significant reforms
will be required to reverse this powerful dynamic. Without policy
distortions being fundamentally corrected, investors should
continue to expect a low growth world.
What are the investment implications to the various asset
classes? Without significant policy changes, we expect equity
markets to return low to mid-single digits, yields on fixed
income assets will remain lower for longer and volatility will be
increasingly difficult to rein in. In this environment, being able
to identify structural breaks or signs of policy reforms can help
investors protect their capital and take advantage
of opportunities as they arise. n
A tale of two countries
Let’s take two countries Greece and U.S. to illustrate policy distortions and imbalances. These two economies could not be more
different in terms of size, composition and competitiveness, yet they both ended up in a debt crisis that can be explained under the
imbalance framework.
Currency distortions and external imbalances
During the 2000s, both the U.S. and Greece enjoyed far stronger currencies than what their fundamentals warranted. Greece
enjoyed a strong currency and lower cost of funds due to its entry into the Eurozone. Although Greece was running persistent and
sizable current account deficits that amounted to 6-8% of GDP, its currency did not adjust accordingly, as the Euro mainly reflected
the strength of the northern European economies. The U.S. had a stronger currency, because its main trading partners (e.g. China
and Japan) kept their currency value low against U.S. Dollar. Over the years, U.S. current account deficits rose steadily. Right before
the financial crisis, U.S. current account deficits reached 6% of GDP. The massive current account deficits in both countries would
be the equivalent of borrowing capital to fund the debt generated internally.
TD Asset Management | The Imbalance Game
5
Different reasons for internal imbalances
Looking at the internal side, the two countries had very different stories for their internal imbalances. In the case of Greece, the
internal imbalance was mainly caused by excessive government spending. The Greek government budget deficit rose from -4% in
2001 to almost -16% in 2009 while outstanding government debt nearly doubled. Unfortunately, while government debt was rising,
investment as a percentage of GDP fell from 25% in the early 2000s to around 10% in 2014. Therefore, the debt servicing capacity of
the country was falling while borrowing accelerated, making the Greek economy ever more fragile. In the U.S., government spending
was also an issue, but the real consumption binge mainly occurred in the household sector before 2008. Because of the ineffective
income and wealth redistribution embedded in U.S. tax policy, the income and wealth inequality gap was getting larger over the
years. To support their daily spending, the average household had to increasingly rely on borrowing. Before the crisis, the U.S.
government policy strongly encouraged home ownership, no matter whether people could afford it or not. This was reflected in the
mortgage repackaging practice of Fannie Mae and Freddie Mac and the fast accumulation of subprime mortgage debt.
Fallout and Aftermath
In both cases, the continued accumulation of debt for spending purposes was not sustainable. Eventually, the market realized that
and both countries went through a severe deleveraging process. But the story is far from over. For Greece, because they remain in
the Eurozone, they still do not have a free floating currency to devalue and a foreign exchange distortion still exists. The heavy debt
burden and contracting fiscal policy only make the situation worse. In the U.S., the shale revolution helped reduce the current account
deficit, but a much stronger U.S. Dollar against all major currencies impeded further improvement. Internally, as U.S. households
continue to deleverage after the crisis, this leverage has been essentially transferred to the government and corporate sectors. The
world is still trapped in an imbalance.
Greece
The United States
Policy Distortion
ƒAdopted
ƒ
Euro as its currency
ƒReckless
ƒ
fiscal policy
External
imbalance
Low
interest
rate
Internal
imbalance
Policy Distortion
ƒManipulation
ƒ
of trading partners
currency value
ƒTax
ƒ and social policy
External
imbalance
Low
interest
rate
Accumulation of debt
Accumulation of debt
Unproductive allocation
of debt
Allocation of debt
Trigger: financial crisis
Trigger: financial crisis
Debt spiral
Struggle to escape
low growth
Internal
imbalance
TD Asset Management | The Imbalance Game
6
Source: Wealth Inequality in the United States Since 1913: Evidence from Capitalized Income Tax data, Emmanuel Saez, Gabriel Zucman, National Bureau of Economic Research
1
The statements contained herein are based on material believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate
or complete. The information does not provide individual financial, legal, tax or investment advice and is for information purposes only. Graphs and charts are used for illustrative purposes only and do not reflect
future values or changes. Past performance is not indicative of future returns. TD Asset Management Inc., The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions
in the information or for any loss or damage suffered.
Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates”
and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest
and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections
about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance.
Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing
any reliance on FLS.
TD Asset Management Inc. is a wholly-owned subsidiary of The Toronto-Dominion Bank.
All trademarks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.