As extensively discussed in the UNCTAD's Trade and Development Report (UNCTAD, 2004, 2005 and 2006), global imbalances have become a major source of systemic risk to the global economy. They can have adverse repercussions in the short and long term on both surplus and deficit economies due to the potentially disruptive effect of a sudden adjustment. As in past financial crises, the growing financial fragility induced by some types of capital inflows, associated with current-account deficits and the threat of an overshooting devaluation, may force deficit economies into contraction, which may spill over to trading partners.
However, if compared to the mid-1990s, the current number of deficit countries is rather small and, apart from the United States, their weight in the world economy is also fairly limited. Nevertheless, there are some regions where risk is highly concentrated, as in Eastern Europe and in some transition economies in Asia. Domestic external imbalances are undoubtedly affected by the determinants of international competitiveness such as wage and price inflation, productivity growth via real exchange rate changes as shaped by the institutions and regulation in the financial, labour and product markets. Nonetheless, it is widely acknowledged that speculative capital flows have a significant cumulative effect on macro aggregates creating systemic risk on both the financial system and real economy.
The paper is organized as follows. Section 2 describes the paradox of the current pattern of world trade and financial imbalances where overvalued currencies may appreciate and undervalued currencies may depreciate. Indeed, the international adjustment mechanism can be undermined by many forms of speculative flows which can be triggered by a combination of global conditions and domestic monetary policies and can lead to financial fragility and to real costs for the affected economies.
Sections 3 to 5 describe the role of "carry trade" positions, broadly defined as highly-leveraged cross-country operations exploiting interest differentials and low currency volatility, in the current diverging pattern of global imbalances and real exchange rates. The real costs of such form of speculation are discussed in section 6. In section 7 and 8 it is pointed out how national and international policies need to address the major sources of imbalance by providing an institutional framework that would reduce the potential for speculative flows and promote coordinated efforts for exchange-rate adjustment and stable real exchange rates.
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