TWN Info Service on Finance and Development (Jul17/01)
10 July 2017
Third World Network
Use prevailing tailwinds to build greater economic resilience, says BIS
Published in SUNS #8494 dated 4 July 2017
Geneva, 3 Jul (Chakravarthi Raghavan*) - Over the past year the global economy
has strengthened further, with growth approaching long-term averages, but faces
risks that could threaten the sustainability of the expansion in the medium
term, the Bank for International Settlements (BIS) says in its 87th annual
report, released in Basel (Switzerland) on 25 June.
"The most promising policy strategy to counter the risks is to take
advantage of the prevailing tailwinds to build greater economic resilience,
nationally and globally," adds the BIS, commonly referred to as the
central bank for the world's central banks.
The full report was presented to its annual general meeting on 25 June. Chapter
VI of the report, titled "Understanding Globalization", had been
released separately a week earlier, in a departure from the usual practice of
issuing the report as a whole.
That chapter, focussing directly on globalization and the "unjustified
backlash" against it in the advanced economies, advocates careful
management of risks to ensure continued openness of economies to trade and
finance which have been "instrumental in raising living standards and
helped lift large parts of the world population out of poverty."
The focus on globalization and the backlash appear to reflect the concerns of
BIS management and its constituent central banks that in the current state of
politics and public debates in the advanced economies, there will be concerted
efforts by some governments to rein in and discipline financial institutions,
putting the brakes on financial globalisation. (See Chakravarthi Raghavan, SUNS
#8485 dated 20 June 2017, "Globalisation risks need careful management,
not backlash, says BIS.")
The same theme seemed to run through the entire report, as well as the speeches
and remarks at the meeting - of BIS General Manager Jaime Caruana (due to demit
office in late 2017 to be replaced by Agustin Carstens, governor of the Bank of
Mexico) and two of the BIS economists - Claudio Borio, Head of the Monetary and
Economic Department, and Hyun Song Shin, Economic Adviser and Head of Research.
All three underscored that trade openness and financial openness were symbiotic
and went together, and putting the brakes on one will have effects on the
In his speech, Caruana said the report aimed to "contribute to the debate
on the global economy among policy-makers, the private sector and
The nature of this debate, he added, has changed a lot over the last year and
the criticism of globalization seems to have gained prominence.
However, the intensified debate and criticism of globalization over the past
year among policy-makers, private sector and academics, appear to be this
group's belated catching-up on the long-ignored deeper under-currents of
grievances of people over growing inequality and stagnant or falling real
incomes and standards of living of the working and middle-classes, whilst a
minuscular minority at the top reaped benefits.
The 2016 Brexit vote in the UK and the outcome of the US Presidential election
(both noted in the Report), are perhaps mere manifestations that caught the
"elites" by surprise, and who are now attempting to understand it and
consider how to counter it.
And the backlash against globalization, in particular, financial globalization,
appears to be related mainly to the trade in finance and financial products
(derivatives of great complexity, used mainly for speculation) de-linked from
the real economy, but as during the Great Financial Crisis (GFC), forcing the
tax-payers to pick up the tab for misbehaviour and failures of financial firms.
In focussing on the backlash to globalization, Caruana (as the BIS report)
suggested that the current global upturn in growth provides opportunities, and
the tailwinds should be used to "marshal support for economic openness and
pay more attention to long-term developments", pursuing policies that
build economic resilience, so as to be better prepared for the next
"shock" or downturn.
In the report, BIS suggests that the facts paint a brighter picture. There are
clear signs that growth has gathered momentum. Economic slack in the major
economies has diminished further; indeed, in some of them unemployment rates
have fallen back to levels consistent with full employment. Inflation readings
have moved closer to central bank objectives, and deflation risks no longer
figure in economic projections. But sentiment has swung even more than facts.
Gloom has given way to confidence.
INFLATION RISKS TO SUSTAINABILITY
The report identifies four risks to global growth: a rise in inflation;
financial stress as financial cycles mature; weaker consumption and investment,
mainly under the weight of debt; and a rise in protectionism. These risks, it
adds, are rooted in what it calls the "risky trinity": unusually low
productivity growth, unusually high debt levels, and unusually limited room for
Evaluating the risks, BIS says that a significant rise in inflation could choke
the expansion by forcing central banks to tighten policy more than expected.
Second, serious financial stress could materialise as financial cycles mature
if their contraction phase were to turn into a more serious bust - as happened
most spectacularly with the GFC. Third, short of serious financial stress,
consumption might weaken under the weight of debt (and the global debt to GDP
ratio is increasing), and investment might fail to take over as the main growth
engine. Finally, a rise in protectionism could challenge the open global
economic order. History shows that trade tensions can sap the global economy's
These risks, BIS says, may appear independent, but they are not. Policy
tightening to contain an inflation spurt could trigger, or amplify, a financial
bust in the more vulnerable countries. The strong post-crisis expansion of
dollar-denominated debt has raised vulnerabilities, particularly in some
emerging market economies (EMEs). An overarching issue is the global economy's
sensitivity to higher interest rates given the continued accumulation of debt
in relation to GDP, complicating the policy normalisation process.
A withdrawal into trade protectionism could spark financial strains and make
higher inflation more likely. And the emergence of systemic financial strains
yet again, or simply much slower growth, could heighten the protectionist
threat beyond critical levels.
Given the risks ahead, BIS says, the most promising policy strategy is to take
advantage of the prevailing tailwinds to build greater economic resilience,
nationally and globally.
At the national level, this means rebalancing policy towards structural
reforms, relieving an overburdened monetary policy, and implementing holistic
policy frameworks that tackle more systematically the financial cycle.
At the global level, it means reinforcing the multilateral approach to policy -
the only one capable of addressing the common challenges the world is facing.
Assessing the economic developments of the past year, the report says that the
change in financial market sentiment was remarkable. Equally remarkable was the
shift in the main forces driving markets. Politics, notably the UK vote to
leave the European Union (Brexit) and above all the US election, took over from
Correspondingly, the "risk-on"/"risk-off" phases, so common
post-crisis in response to central banks' words and actions gave way to a more
differentiated pattern in sync with political statements and events. That said,
central banks continued to exert a significant influence on markets.
[Evidence that financial markets are still highly sensitive to the remarks of
central bankers came last week from Sintra (the Portuguese coastal resort
town), where the ECB (European Central Bank) forum of central bankers met, and
eurozone central bankers gathered for their annual meetings on June 27.
According to a report in the Financial Times, at that meeting, ECB President
Mario Draghi gave a speech that seemed to take on a hawkish tone compared to
his remarks at the ECB itself on 7 June.
[And on the next day (28 June) at the central bankers' conclave, the speech of
Mark Carney, Bank of England governor, was interpreted as advocating an
interest rate rise, having rejected it in London as recently as last week. The
perception of a tightening European monetary outlook pushed both the euro and
sterling sharply higher and forced central bank officials into introspective
discussions on their communications strategies. The FT report said that for
seasoned hands such as Peter Praet, the ECB's chief economist, the experience
highlighted his warnings earlier this year that central bankers should not say
too much too soon about the details of the ECB's exit strategy. The chief
economist had cautioned that markets had become "particularly sensitive to
any perceived change in the future course of monetary policy".]
In terms of sustainability of the growth momentum, BIS says that its brief
review of economic developments of the past year indicates that the global
economy's performance has improved considerably and that its near-term
prospects appear to be the best in a long time.
The central scenario delineated by private and official sector forecasts points
to further gradual improvement: headwinds abate, the global economy gathers
steam, monetary policy is gradually normalised, and the expansion becomes
entrenched and sustainable. Indeed, the financial market sentiment is broadly
consistent with this scenario.
Assessing the risks of a spurt in inflation, BIS says that since the great
financial crisis and its effects, there are prima facie reasons to believe that
inflation, already edging up, could increase significantly. More importantly,
economic slack is vanishing, and this is happening in several countries
simultaneously, suggesting that it would be unwise to take much comfort from
the fact that higher inflation has recently mirrored mainly a higher oil price:
they could point to greater inflation momentum going forward.
FINANCIAL CYCLES, CONSUMPTION AND INVESTMENT
At the same time, a substantial and lasting flare-up of inflation does not seem
likely. While the deeper reasons for these developments are not well understood
and an inflation spurt cannot be excluded, it may not be the main factor
threatening the expansion, at least in the near term. Judging from what is
priced in financial assets, financial market participants also appear to hold
In this light, the potential role of financial cycle risks comes to the fore.
The main cause of the next recession will perhaps resemble more closely that of
the latest one - a financial cycle bust.
Such risks are not apparent in the countries at the core of the GFC (the US,
the UK or Spain), where some private sector deleveraging has taken place and
financial cycle expansions are still comparatively young. The main source of
near-term concerns in crisis-hit economies is the failure to fully repair
banks' balance sheets in some countries, notably in parts of the euro area,
especially where the public sector's own balance sheet looks fragile.
Rather, the classical signs of financial cycle risks are apparent in several
countries largely spared by the GFC, comprising several EMEs (emerging market
economies), including the largest, as well as a number of advanced economies,
notably some commodity exporters. In all of these economies, interest rates
have been very low, or even negative, as inflation has stayed low, or even
given way to deflation, despite strong economic performance.
Financial cycles in this group are at different stages. In some cases, such as
China, the booms are continuing and maturing; in others, such as Brazil, they
have already turned to bust and recessions have occurred, although without
ushering in a full-blown financial crisis.
EMEs face an additional challenge: the comparatively large amount of FX
(foreign exchange) debt, mainly in US dollars. From 2009 to end-2016, US dollar
credit to non-banks located outside the United States - a bellwether BIS
indicator of global liquidity - soared by around 50% to some $10.5 trillion;
for those in EMEs alone, it more than doubled, to $3.6 trillion.
Compared with the past, several factors mitigate the risk linked to FX debt.
Countries have adopted more flexible exchange rate regimes, and have also built
up foreign currency war chests, which should cushion the blow if strains
emerge. And the amounts of FX debt in relation to GDP are, on balance, still
not as high as before previous financial crises.
More generally, while leading indicators of financial distress provide a
general sense of a build-up of risk, they have a number of limitations. In
particular, they tell us little about the precise timing of its
materialisation, the intensity of strains or their precise dynamics.
Also, policymakers have taken major steps post-crisis to improve the strength
of regulatory and supervisory frameworks. Many EMEs have had recourse to a wide
array of macro-prudential measures to tame the financial cycle. While these
have not succeeded in avoiding the build-up of outsize financial booms, they
can make the financial system more resilient to the subsequent bust.
As the experience of Brazil indicates, this may not prevent a recession, but it
may limit the risk of a financial crisis. These limitations suggest that the
indicators need to be treated with caution.
Short of any serious financial strains, the expansion could end because of
weakness in domestic aggregate demand.
In many countries, the recent expansion has been consumption-led, with
consumption growth outpacing that of GDP. By contrast, investment has been
comparatively subdued until recently. Could consumption weaken? And what are
the prospects for a sustained strengthening of investment?
While consumption could weaken as a result of smaller employment gains as
capacity constraints are hit, the more serious vulnerabilities reflect the
continued accumulation of debt, sometimes on the back of historically high
asset prices. BIS research has uncovered an important but under-appreciated
role of debt service burdens in driving expenditures, pointing to
These are apparent in economies that have experienced household credit booms
post-crisis, often alongside strong property price increases, including several
small open economies and some EMEs.
Increases in interest rates beyond what is currently priced in markets could
weaken consumption considerably. By contrast, in some crisis-hit countries,
such as the United States, the safety cushion is considerably larger following
the deleveraging that has already taken place.
While interest rates matter for investment, a bigger role is played by profits,
uncertainty and cash flows. In EMEs, a cause for concern has been the sharp
increase in corporate debt in several economies, sometimes in foreign currency.
China stands out, given the combination of unprecedented debt-financed
investment rates and signs of excess capacity and unprofitable businesses. A
sharp slowdown there could cause much broader ripples in EMEs, including
through a slump in commodity prices.
Since the GFC, protectionist arguments have been gaining ground. They have been
part of a broader social and political backlash against globalization. Rolling
back globalization would strike a major blow against the prospects for a
sustained and robust expansion. Investment would be the first casualty, given
its tight link with trade. But the seismic change in institutional frameworks
and policy regimes would have a broader and longer- lasting impact.
REAL AND FINANCIAL GLOBALIZATION INTERTWINED
While there is a natural tendency to discuss real and financial globalization
separately, the two are intertwined. Exports and imports rely heavily on
international financing. Transnational ownership of companies through foreign
direct investment (FDI) boosts trade, spreads organisational and technological
know-how, and gives rise to global players. Banks and other service providers
tend to follow their customers across the world.
Financial services are themselves an increasing portion of economic activity
and trade. And the relevance of national borders is further blurred by the
overwhelming use of a handful of international currencies, mostly the US dollar,
as settlement medium and unit of account for trade and financial contracts.
[Some of the propositions and arguments above seem questionable, however. SUNS]
Across countries, the pattern of financial linkages mirrors rather well that of
trade. Historically, there have been periods, such as the Bretton Woods era, in
which policymakers sought greater trade integration while at the same time
deliberately limiting financial integration, so as to retain more policy
autonomy. But, over time, the regimes proved unsustainable, and financial
integration grew apace. That said, the financial side has also developed a life
of its own.
Across countries, this reflects in particular the benefits of agglomeration,
which cause financial activity to concentrate in financial centres, and tax
arbitrage, which encourages companies to locate headquarters in specific
countries. Since the early 1990s financial linkages have far outstripped trade,
in contrast to what available data suggest about the first globalization wave (that
ended with world war one).
There is some evidence that globalization has slowed post-crisis, but it is not
in retreat. Trade in relation to world GDP and GVCs (global value chains) have
plateaued. And while financial integration broadly defined seems to have
moderated, bank lending has pulled back.
However, a closer look at the BIS statistics indicates that the contraction
largely reflects a pullback by euro area banks and is regional in nature. Banks
from Asia and elsewhere have taken over, and integration has not flagged.
Moreover, securities issuance has outpaced bank lending, in line with the rise
of institutional investors and asset managers.
From a policy perspective, the reasons for the slowdown matter. The slowdown
would be less of an issue if it simply reflected cyclical factors and
unconstrained economic decisions. Much of the decline in trade and financial
linkages seems to have that character. It would be more of a concern if it
reflected national biases. In both trade and finance, there are signs that this
too may have started to occur.
Hence, the increase in trade restrictions and in ring-fencing in the financial
sector. No doubt some of those decisions may be justified, but they could
herald a broader and more damaging backlash.
Formal statistical evidence, casual observation and plain logic indicate that
globalization has been a major force supporting world growth and higher living
standards. Globalization has helped lift large parts of the world population
out of poverty and reduce inequality between countries.
At the same time, it is also well known that globalization poses challenges.
First, its benefits may be unevenly distributed, especially if economies are
not ready or able to adapt. Trade displaces workers and capital in those
sectors that are more exposed to international competition. And it may also
increase income inequality in some countries.
Opening up trade with countries where labour is abundant and cheap puts
pressure on wages in those where it is scarcer and more expensive. It can thus
erode labour's pricing power, tilt the income distribution towards capital, and
widen the skilled/unskilled labour wedge.
Second, opening up the capital account without sufficient safeguards can expose
the country to greater financial risks. The empirical evidence confirms, but
also qualifies, the impact on labour markets and income distribution.
And while studies have found an impact on income inequality, they have
generally concluded that technology has been much more important: the mechanisms
are similar and naturally interact, but the spread of technology across the
whole economy has made its influence more pervasive.
It is also well recognised by now that greater financial openness can channel
financial instability. Just as with domestic financial liberalisation, unless
sufficient safeguards are in place, it can increase the amplitude of financial
booms and busts - the so-called "procyclicality" of the financial
system. The free flow of financial capital across borders and currencies can
encourage exchange rate overshooting, exacerbate the build-up of risks and
magnify financial distress - that is, increase the system's "excess
elasticity". The dominant role of the US dollar as international currency
adds to this weakness, by amplifying the divergence between the interests of
the country of issue and the rest of the world. Hence, the outsize influence of
US monetary policy on monetary and financial conditions globally.
These side effects of globalization do not imply that it should be rolled back;
rather, they indicate that it should be properly governed and managed. A
roll-back would have harmful short-term and long-term consequences. In the
short term, greater protectionism would weaken global demand and jeopardise the
durability and strength of the expansion, by damaging trade and raising the
spectre of a sudden stop in both investment and FDI.
In the longer term, it would endanger the productivity gains induced by greater
openness and threaten a revival of inflation.
Given the risks ahead, how can policymakers best turn the current upswing into
sustainable and robust global growth? Over the past year, a broad consensus has
been emerging about the need to rebalance the policy mix, lightening the burden
on monetary policy and relying more on fiscal measures and structural reforms.
Still, views differ about policy priorities.
Much of the current policy discourse revolves around two propositions. The
first is that policymakers are able to fine-tune the economy, by operating
levers that influence aggregate demand, output and inflation in a powerful and
predictable way. The second is that there is a neat distinction between the
short run, the preserve of aggregate demand, and the long run, the preserve of
There is clearly some truth in both propositions, though reality is much more
nuanced. It is all too easy to over-estimate policymakers' ability to steer the
economy. Moreover, aggregate demand and supply interact so that the short and
long run blend into each other.
The post-crisis experience has proved that it is much harder than expected to
boost growth and inflation despite unprecedented measures. And the recession,
itself the legacy of the previous unsustainable financial boom, appears to have
left profound scars: output losses have been huge and productivity growth
This experience highlights the need to evaluate policy in a long-term context.
Rather than seeking to fine-tune the economy, a more promising approach would
be to take advantage of the current strong tailwinds to strengthen the
economy's resilience, at both the domestic and global level. Resilience,
broadly defined, means more than just the capacity to withstand unforeseen
developments or "shocks".
It also means reducing the likelihood that shocks will materialise in the first
place, by limiting policy uncertainty and the build-up of vulnerabilities, such
as those stemming from financial imbalances. And it means increasing the
economy's adaptability to long-term trends, such as those linked to ageing
populations, slowing productivity, technology or globalization.
DOMESTIC POLICY CHALLENGES
Building resilience domestically is a multifaceted challenge involving,
monetary, fiscal and structural policies as well as their role in tackling the
financial cycle. There is a broad consensus now that monetary policy has been
overburdened for far too long. In the process, central bank balance sheets have
become bloated, policy interest rates have been ultra-low for a long time, and
central banks have extended their direct influence way out along the sovereign
yield curve as well as to other asset classes, such as private sector debt and
Building resilience would suggest attaching particular importance to enhancing
policy space, so as to be better prepared to tackle the next recession. This,
in turn, would suggest taking advantage of the economy's tailwinds to pursue
normalisation with a steady hand as domestic circumstances permit.
Normalisation presents a number of tough challenges. Many of them stem from the
journey's starting point - the unprecedented monetary conditions that have
Heightened uncertainty naturally induces central banks to move very gradually
with interest rates, and even more so with their balance sheets, with changes
that are well telegraphed.
On the other hand, that very gradualism implies a slower build-up of policy
space. And it may also induce further risk-taking and promote the conditions
that make a smooth exit harder. Trade-offs are further complicated by the
spillovers that domestic actions may have globally, especially in the case of
the US dollar.
As a result, the road is bound to be bumpy. Normalisation may well not proceed
linearly, but in fits and starts, as central banks test the waters in light of
evolving conditions. And yet it is essential for financial markets and the
broader economy to shake off their unusual dependence on central banks'
Building resilience through fiscal policy has two dimensions. The first is to
prioritise the use of any available fiscal space: to support growth-friendly
structural reforms; reinforce support for globalization by addressing the
dislocations it can cause; last but not least, public support for balance sheet
repair remains a priority where private sources have been exhausted. Resolving
non-performing loans is paramount for unlocking the financing of productive
What would be unwise at the current juncture would be simply to resort to
deficit spending where the economy is close to full employment. This does not
rule out the streamlining of tax systems or judicious and well executed public
investments. But, as always, implementation is of the essence and far from
straightforward, as the historical record suggests.
The second dimension concerns enhancing fiscal space over time. A precondition
is its prudent measurement, incorporating in current methodologies a number of
factors that tend to be underplayed or excluded - the need for a buffer for
potential financial risks, realistic financial market responses to higher
sovereign risks, and the burden of ageing populations. A prudent assessment of
fiscal space could anchor the needed medium-term consolidation of public
Building resilience through structural policies is essential. Unfortunately,
far from speeding up, implementation has been slowing down. The needed
structural reforms are largely country-specific. Their common denominator is
fostering entrepreneurship and the rapid take-up of innovation, limiting
In addition, an under-appreciated aspect is to ensure the flexible reallocation
of resources, given the debilitating impact rigidities can have on the
economy's shock-absorbing capacity and on productivity growth. Steps in that
direction would also go a considerable way towards addressing the dislocations
It would be important that monetary, fiscal and even structural measures be
part of a shift towards policy frameworks designed to address a critical source
of vulnerabilities - the financial cycle. Tackling the financial cycle would
call for more symmetrical policies. Otherwise, over long horizons, failing to
constrain financial booms but easing aggressively and persistently during busts
could lead to successive episodes of serious financial stress, a progressive
loss of policy ammunition and a debt trap.
From this perspective, there are some uncomfortable signs: monetary policy has
been hitting its limits; fiscal positions in a number of economies look
unsustainable, especially if one considers the burden of ageing populations;
and global debt-to-GDP ratios have kept rising.
GLOBAL CHALLENGES NEED CLEAR RULES OF THE GAME
While there is a lot that domestic policy can do to build resilience, certain challenges
call for a global response. The goal is to set out a clear and consistent
multilateral framework - the rules of the game - for actions to be taken either
at the national level or jointly internationally.
A first priority is to finalise the financial (prudential) reforms under way. A
core of common minimum standards in the financial sphere is a precondition for
global resilience in an integrated financial world. Such standards avoid a
perilous race to the bottom. Among the reforms, completing the agreement on
minimum capital and liquidity standards - Basel III - is especially important,
given the role banks play in the financial system.
The task is to achieve agreement without, in the process, diluting the
standards in the false belief that this can support growth. A sound
international agreement, supported by additional measures at the national
level, combined with the deployment of effective macro-prudential frameworks,
would also reduce the incentive to roll back financial integration.
A second priority is to ensure that adequate crisis management mechanisms are
in place. A critical element is the ability to provide liquidity to contain the
propagation of strains. And that liquidity can only be denominated in an
international currency, first and foremost the US dollar, given its dominant
At a minimum, this means retaining the option of activating, when circumstances
require, the inter-central bank swap arrangements implemented post-crisis.
A third priority is to ensure that open trade does not become a casualty of
protectionism. A key to postwar economic success has been increased trade
openness built around the multilateral institutions that support it.
The arrangements are by no means perfect. For instance, the World Trade Organization's
global trading rounds have ground to a halt and its dispute settlement
mechanism is overburdened.
Even so, it would be a mistake to abandon multilateralism: the risk of
tit-for-tat actions is simply too great. While open trade creates serious challenges,
rolling it back would be just as foolhardy as rolling back technological
A fourth, complementary, priority is to seek a more level playing field in
taxation. Tax arbitrage across jurisdictions is one factor that has fuelled
resentment of globalization and has no doubt contributed to income and wealth
inequality within countries, including by encouraging a race to the bottom in
corporate taxation. Several initiatives have been under way under the aegis of
the G20. But efforts in this area could be stepped up.
Beyond these priorities, it is worth exploring further the room for greater
monetary policy cooperation - the fifth area. Cooperation would help limit the
disruptive build-up and unwinding of financial imbalances. In increasing degree
of ambition, options include enlightened self-interest, joint decisions to
prevent the build-up of vulnerabilities, and the design of new rules of the
game to instil more discipline in national policies.
While the conditions for tighter forms of cooperation are not fulfilled at
present, deepening the dialogue to reach a better agreement on diagnosis and
remedies is a precondition for further progress.
These courses of action recognise that, just like technology, globalization is
an invaluable common resource that offers tremendous opportunities. The
challenge is to make sure that it is perceived as such rather than as an
obstacle, and that those opportunities are turned into reality.
It is dangerous for governments to make globalization a scapegoat for the
shortcomings of their own policies. But it is equally dangerous not to
recognise the adjustment costs that globalization entails.
Moreover, says BIS, managing globalization cannot be done just at national
level; it requires robust multilateral governance. For lasting global
prosperity, there is no alternative to the sometimes tiring and frustrating
give-and-take of close international cooperation.
[* Chakravarthi Raghavan is the Editor Emeritus of the SUNS. The full BIS
report can be found at: http://www.bis.org/publ/arpdf/ar2017e.htm]