By Ka Yan Ng
NEW YORK (Reuters) - The world could face a prolonged spell of financial chaos unless more is done to tackle growing current account imbalances, and it won't be achieved through exchange rate adjustment alone, Bank of Canada Governor David Dodge said on Wednesday.
In remarks to a New York business audience, Dodge said there were risks the imbalances would persist "until they are resolved in a disorderly way."
Dodge also said U.S. external indebtedness could not continue growing forever. The U.S. current account deficit is currently running near 7 percent of gross domestic product (GDP).
"There is no compelling reason to believe that historical and fundamental economic and financial restraints do not apply to the world economy today ... there is every reason to believe that a market adjustment to these imbalances will take place," he said.
To promote a smoother adjustment, policymakers need to make progress on several fronts and not just cherrypick among priorities, such as microeconomic policies to promote productivity, developing well-functioning markets and flexible exchange rates.
"We can't delude ourselves into thinking that economic imbalances will be resolved in an orderly way through exchange rate adjustment alone. Progress has to be extensive, international and simultaneous," Dodge said.
He called for the creation of a new international framework -- based on a revitalized International Monetary Fund -- to come up with mechanisms to resolve imbalances, saying "collective action is needed now" to minimize the chances of a major economic disruption.
In remarks directed at China, he said the most important policy priority was probably to increase exchange rate flexibility, but added this alone would not solve the imbalances.
Dodge said he was worried by the gap between the growing current account deficit in the United States and large surpluses elsewhere, particularly in Asia.
"Economic theory and history tell us that external indebtedness cannot keep growing indefinitely as a share of a country's GDP -- even for a country like the United States with its reserve currency status," the Canadian central banker said.
There were risks of slowing U.S. demand or investors dramatically reducing their exposure to the United States, he said, both of which could cause major disruption in world financial markets.
He also told reporters that Canada's economy could be "sideswiped" if there were a disorderly adjustment to global imbalances.
Dodge expressed concern about labor market rigidities in Europe and Japan, saying they were significant barriers to adjustment, and said he noted "with some dismay" rising economic nationalism in Asia, Europe and the United States when it came to direct foreign investment.
While the speech made no mention of interest rates or the domestic Canadian economy, Dodge later told reporters the Bank of Canada sets policies based on domestic economic conditions, just as the Federal Reserve considers how to apply policy.
"We have to set monetary policy in respect of conditions in Canada so in that sense policies are independent and appropriately so," he said.
The central bank is widely expected to raise rates again next month by a quarter percentage point to bring the overnight rate to 4 percent. Some market observers predict it could be the last rate increase in this credit tightening cycle.
Regarding the outlook for the world economy, Dodge said there is "greater probability that we will see slower growth than faster growth" in the global economy in 2007. Several different forecasts point to world economic growth in 2007 of around 4 percent, he noted.
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