Service on Finance and Development (Jun18/06)
policy mix for more balanced growth, says BIS
Geneva, 26 Jun (Chakravarthi Raghavan*) - Thanks to concerted efforts of central banks and their supportive policies since the Great Financial Crisis (GFC), averting a repeat of the Great Depression, consensus forecasts see continuing growth in the global economy for the next couple of years, marking one of the longest post-war expansions, with gradual convergence of inflation towards objectives.
However, with central banks and monetary policies largely left to bear the burden, with other policies, not least supply-side structural ones, failing to take the baton, it has left a legacy of swollen private and public sector balance sheets and higher debts, with the path ahead a narrow one with several risks.
As the global economy reaches or even exceeds potential, it is time to take advantage of these favourable conditions for a more balanced policy mix to promote a sustainable expansion.
This was the thrust of the messages that were sought to be put across at the Annual General Meeting on Sunday (24 June) of the Bank for International Settlements (BIS), the central bank for the world's central banks.
The message was in the Annual Economic Report of the BIS, and in speeches and remarks of its General Manager Agustin Carstens (former Governor of the Mexican Central Bank) and his top aides - Claudio Borio (Head of the Monetary and Economic Department) and Hyun-Song Shin (Economic Advisor and Head of Research).
The policy advice for change, namely more balanced monetary and fiscal policies, and gradual raising of interest rates, has been a recurring theme of the BIS for the last few years, but has been generally ignored so far. It remains to be seen whether this year's message will have some effect.
The Basel-based BIS, from this year on, has split its usual annual publication into two parts, one the Annual Economic Report, and the other the Annual Report devoted to the BIS activities and balance sheets, and those of various associated groups housed at BIS.
This Annual Report, apart from normal charts, graphics and tables, has been jazzed up with pictures of individuals running or heading these groups.
Whether the "flashy" report, more like a house organ, will add to the weight of its messages and thrust remains to be seen.
In the Annual Economic Report, BIS notes that since the Great Financial Crisis (GFC) engulfed the world 10 years ago, and the world's financial system was on the brink of collapse, thanks to concerted efforts of the world's central banks and their accommodative stance, a repeat of the Great Depression was avoided.
Since then, historically low, even negative, interest rates and unprecedentedly large central bank balance sheets have provided important support for the global economy and have contributed to the gradual convergence of inflation toward s objectives.
Still, central banks were largely left to bear the burden of the recovery, with other policies, not least supply-side structural ones, failing to take the baton.
These actions by central banks helped lay the groundwork for the resumption of growth. But, in the process, they have been one factor behind the legacy of swollen private and public sector balance sheets and higher debts that shapes the road ahead.
For the next couple of years, consensus forecasts see the trend continuing, marking one of the longest post-war expansions.
Despite the softer patch in the first quarter of 2018 and some jitters in emerging market economies (EMEs), the forecasters' central scenario is still for global growth to exceed potential, reducing unemployment further, with economies testing capacity limits. Investment is expected to strengthen, boosting productivity over time. And fiscal expansion should provide additional near-term stimulus.
The current scenario is somewhat unusual in the post-war period. It is not common to anticipate such strong growth so late in the expansion, when capacity constraints start biting, with only modest signs of an inflation threat. The reasons for this picture are much debated.
However, the path ahead is a narrow one, says BIS, with several risks. As the global economy reaches or even exceeds potential, it is time to take advantage of the favourable conditions to put in place a more balanced policy mix to promote a sustainable expansion.
Assessing the risks ahead in some detail, the report concludes that medium-term risks are material, although there are cross-country differences.
In some respects, the risks mirror the unbalanced post-crisis recovery and its excessive reliance on monetary policy. Where financial vulnerabilities exist, they have been building up, in their usual gradual and persistent way.
More generally, financial markets are overstretched and there has been a continuous rise in the global stock of debt, private plus public, in relation to GDP. This has extended a trend that goes back to well before the crisis and has coincided with a long-term decline in interest rates.
In some countries largely spared by the GFC, for quite some time there have been signs of a build-up of financial imbalances. Fortunately, much has been done to strengthen the financial system's resilience.
The post-crisis financial reforms, not least Basel III and the implementation of macro-prudential frameworks, have substantially bolstered the banking system.
[In the United States, just a year after it took partial effect, the so-called fiduciary rule - a requirement that financial professionals put their customers' interests ahead of their own with respect to the customers' retirement accounts - has effectively died, with a federal appeals court ruling that the US labour department under President Obama had exceeded its authority in instituting this rule. SUNS]
And in China, the largest economy where the signs of imbalances are evident, the authorities have taken steps to rebalance the expansion and rein in some of the more serious financial excesses.
Against this backdrop, a number of developments could lead to the materialisation of risks, threatening the economic expansion in the medium term. In all of them, financial factors seem destined to play a prominent role, either as a trigger or as an amplifying mechanism.
Indeed, the role of financial forces in business fluctuations has grown substantially since the early 1980s, when financial liberalisation took hold.
And post-crisis, the weight of non-bank intermediaries, such as asset managers and institutional investors, has risen substantially, and is likely to influence the dynamics of any future episodes of financial stress, in familiar but also some unexpected ways.
One possible trigger of an economic slowdown or downturn could be an escalation of protectionist measures. Its impact could be very significant, if such escalation was seen as threatening the open multilateral trading system.
Indeed, there are signs that the rise in uncertainty associated with the first protectionist steps and the ratcheting-up of rhetoric have already been inhibiting investment. Moreover, were the recent reversal in the US dollar depreciation to continue, trade negotiations would become more complicated.
A second possible trigger could be a sudden decompression of historically low bond yields or snap-back in core sovereign market yields, notably in the United States. This could take place in response to an inflation surprise and the perception that central banks will have to tighten more than anticipated.
In the United States, the prospective heavy issuance of government debt, combined with the gradual unwinding of central bank purchases, could add to this risk.
Importantly, the (inflation) surprise need not be a large one, as indicated by the financial markets' wobble in February in response to slightly stronger than anticipated US wage growth. And the impact would spread globally, given the weight of the US economy and the dominant role of the dollar in global financial markets.
A third trigger could be a more general reversal in risk appetite. Such a reversal could reflect a range of factors, including disappointing profits, the drag of the contraction phase of financial cycles where these have turned, a souring of sentiment vis-a-vis EMEs, or untoward political events threatening stability in some large economies.
From this perspective, recent events in the euro area are a source of concern, as reflected in the widening of spreads on Italian and Spanish bonds.
In contrast to the snap-back scenario, this third trigger would usher in a further compression of term premia in those core sovereign markets that benefited from a flight to safety.
Indeed, in April signs of strain did emerge in the most vulnerable EMEs, beginning in Argentina and Turkey, as the US dollar began to appreciate and financial conditions in international markets started to tighten.
At the time of writing (in mid-May), it is too early to tell whether the strains will remain contained or will spread further, says BIS.
Most EMEs, BIS says, are better placed to confront financial stress now than they were in the mid-1990s. They have taken steps to strengthen their defences, by building reserves, adopting more systematic macro-prudential measures, improving their current account positions and adopting more flexible exchange rate regimes. This should provide them with some more room for manoeuvre were global financial conditions to tighten further.
Nevertheless, some pitfalls remain. The shift in the pattern of financial intermediation towards greater borrowing through the bond market has reduced rollover risk but introduced greater duration risk.
Portfolio investors with limited tolerance for losses may amplify price fluctuations should they attempt to reduce exposures simultaneously.
More generally, non-banks have been the largest borrowers; if they found themselves under financial strain, they might curtail operations and employment. A slowdown in the real economy may be the risk to watch for if EMEs continue to experience tightening financial conditions.
Looking further ahead, if the global economy successfully navigates the choppy waters just described, the expansion could continue.
But then, almost inevitably, supported by easy financial conditions, financial imbalances and, above all, the aggregate debt-to-GDP ratio could rise further.
Financial market complacency, low volatility and excessive risk-taking would continue.
Limited market discipline would induce further poor resource allocation, including through the survival of ultimately unprofitable firms and weaker incentives for sovereigns to ensure fiscal space. All this would make the subsequent adjustment more painful.
Such a further rise in global debt would be especially worrying. Not only would it make it harder to raise interest rates to more normal levels without threatening the expansion, given the associated rise in debt service burdens - a kind of "debt trap". It would also narrow the room for manoeuvre to address any downturn, which will come sooner or later.
What can policy do to ensure the current expansion is more sustainable and balanced?
There are several possible lines of action that, if combined, would support each other. Their common theme is to focus firmly on longer horizons, since both monetary and fiscal expansions work to a considerable extent by borrowing demand from the future. And when the future becomes today, there is inevitably a price to be paid.
This puts a premium on taking advantage of the current highly favourable conditions to redress the balance. Such policy adjustments would be consistent with the implementation of a broader macro-financial stability framework, in which the various policies would work in tandem to ensure macroeconomic and financial stability while raising long-term sustainable growth.
The first line of action is to redouble efforts to implement structural policies - the only way to raise sustainable growth without generating inflationary pressures. The essence of the reforms is to make product and labour markets more flexible, enabling them to allocate resources more efficiently and to absorb technical innovations more easily.
One important element here is also to safeguard the open multilateral trading order that has served the global economy so well during the past decades.
Unfortunately, the post-crisis record in structural reforms has fallen far short of what is desirable: since 2011 the pace has actually slowed down. Moreover, recent protectionist rhetoric and actions do not augur well.
The second line of action is to strengthen further the resilience of the financial system. This requires completing and consistently implementing the post-crisis financial regulatory reforms.
Ideally, where appropriate, this should be supported by steps to remove structural impediments to efforts of banks to attain sustainable profitability, which is critical to absorb any losses smoothly and swiftly should these materialise at some point.
Strengthening resilience also calls for the active deployment of macro-prudential measures in those economies where financial imbalances have been building up and the improvement of macro-prudential frameworks more generally.
In both cases, the non-bank sector, notably asset managers and institutional investors, deserves closer attention, to complete unfinished business there.
The third line of action is to ensure the sustainability of public sector finances and to avoid pro-cyclical fiscal expansions. The importance of this issue cannot be emphasised enough. Public debt has risen to new peacetime highs in both advanced and emerging market economies.
And, as history indicates, fiscal space is likely to be overestimated in countries where financial imbalances have been building up. With due regard for country-specific circumstances, fiscal consolidation is a priority.
The final line of action concerns monetary policy. Monetary policy normalisation is essential in rebuilding policy space.
It can create room for counter-cyclical policy, help reduce the risk of the emergence of financial vulnerabilities, and contribute to restraining debt accumulation.
That said, given the unprecedented starting point, the uncertainties involved and persistently low inflation in many jurisdictions, the path ahead is quite n arrow, with pitfalls on either side.
It requires striking and maintaining a delicate balance between competing considerations, notably achieving inflation objectives in the short run and avoiding the risk of encouraging the further build-up of financial vulnerabilities in the longer run.
While the right approach will naturally depend on country-specific conditions, a couple of general observations are possible.
One is that treading the path will call for flexibility in the pursuit of inflation objectives. This applies in particular to moderate inflation shortfalls, given the benign structural dis-inflationary pressures still at work.
The other is that policymakers will need to maintain a steady hand, avoiding the risk of over-reacting to transitory bouts of volatility. Given initial conditions, the journey is bound to be bumpy.
Financial market ructions will no doubt occur. Higher volatility per se is not a problem as long as it remains contained; it is actually healthy whenever it helps inhibit unbridled risk-taking.
In his speech at the AGM, General Manager Carstens said that the central banking community should feel satisfied with the state of the global economy today.
On changes in monetary stance already beginning, Carstens said that the recent tightening of financial conditions, including the still very gradual and largely expected dollar appreciation, has already sparked some stresses.
This is particularly visible for the most vulnerable emerging market economies - Argentina and Turkey. Other countries have also been affected, but to a lesser extent.
While it is too early to tell whether the strains will remain contained or put more countries under pressure, portfolio investment has been flowing out of emerging market economies.
Balance sheets of most banks have greatly improved and the adjustment to the new, Basel III requirements is basically complete. But improvements are not uniform. In some crisis-affected advanced economies, banks have not fully healed, and business models have not yet fully adapted to the new environment.
As a result, market valuations of some banks remain below book value, and ratings of some banks are lower when assessed on a standalone basis, suggesting that relatively small shocks could easily erode confidence.
In addition, in some advanced economies, concerns about fiscal sustainability have led to spikes in sovereign spreads, with widespread effects on bank valuations and financial markets more generally.
With these and other vulnerabilities looming, a number of developments could threaten the economic expansion under way.
One could be a further escalation of protectionist measures, undermining the open multilateral trading system which has laid the foundation for much of the global progress in improving living standards. Indeed, there are signs that the ratcheting-up of protectionist pressures has already weighed on investment.
Another threatening development could be a sudden decompression of historically low bond yields, a "snap-back", in core sovereign markets.
A greater share of credit is now intermediated by non-banks, especially asset managers. This means interactions among agents become more complex, with consequences for asset prices and financial stability that can be harder to anticipate.
As shown earlier this year, small events, including mild inflation surprises, can easily scare overstretched financial markets. Moreover, as asset management has become more global, international repercussions can quickly multiply.
Another risk is a reversal in global risk appetite, possibly triggered by concerns about debt sustainability of some sovereigns, as happened recently in the euro area periphery.
In contrast to the snap-back scenario, this could usher in a further compression of term premia in those sovereign markets benefiting from the flight to safety, rather than a widening.
Many of these risks have to be considered in the light of turning financial cycles in some economies and aggregate debt burdens, both public and private, that have continued to increase post-crisis.
Turning financial cycles can carry the seeds of risk, including recessions. High public debt is obviously constraining fiscal policy.
The economic upswing also still relies on extraordinary support from central banks. However, central banks may find it increasingly difficult to manage both financial stability and price stability objectives. Their room for manoeuvre is clearly more limited than before the GFC.
Interest rates are significantly lower and central bank balance sheets much larger, making easing policies harder. This applies in different ways and degrees to both advanced and emerging market economies. Many of the latter have precious little room for policy mistakes.
Policy actions today should encourage the establishment of frameworks that avoid the further build-up of risks, promote sustainable growth, and prepare economies to adapt to technological and other structural changes.
This calls for policies that have long horizons and that take account of the various inter-linkages.
Fiscal policy must ensure that public finances are on a sustainable footing. Compared with pre-crisis, public sector debt in relation to GDP has increased further, leaving very limited space.
Besides implementing agreed financial regulatory measures, maintaining and deepening financial reforms is still necessary.
This means further strengthening the resilience of banking systems in both balance sheet and business model dimensions. It's also key to assess and tackle risks in non-banking sectors, including those related to liquidity mismatches and interactions that can lead to adverse effects.
Structural reforms should reinforce the ability of economies to absorb shocks and avoid a further build-up of imbalances.
Moreover, they need to encourage workers, employers and consumers to adapt to ongoing structural changes, many triggered by technological advances.
In the current political environment, maintaining an open trading system is one of the toughest tasks. But there is no greater need today than to defend the system that has fostered such enormous global gains.
Monetary policy is also crucial over a longer horizon.
Monetary policy normalisation among advanced economies is essential in rebuilding policy space, with a focus on enhancing resilience to slow-building threats.
This means responding to signs of inflation resurfacing, while not over-reacting to moderate inflation shortfalls or transient bouts of volatility.
This would create room for counter-cyclical policy, dilute the risk of financial vulnerabilities, and slow down debt accumulation.
For some emerging market economies, the adoption of a tighter monetary policy stance might be necessary sooner rather than later, given the likelihood of investors' portfolio adjustments in anticipation of tighter global financial conditions.
For these countries, the presence of a congruent macro-financial framework will be of the essence in the period ahead.
The role of macro-prudential frameworks in ensuring more resilience is now more widely recognised. Reaping the full benefits of this intellectual shift requires embedding an explicit macro-prudential orientation to regulation and
supervision into broader and more holistic macro-financial stability frameworks.
Those must include monetary, fiscal and structural policies. Only such well-constructed frameworks can help ensure financial and macroeconomic stability while boosting overall growth on a sustainable basis.
In all of this, it is essential to consider the rapid changes that technological advances have brought about in financial services, including not just fintech but, potentially more importantly, the foray of the big technology firms into financial services. The latter could erode valuations of incumbents and pose existential threats.
"We are just seeing the early signs, but we may well be at the cusp of a new paradigm."
Some of these new risks stem from the emergence of cryptocurrencies. They are impractical as a means of payment, offer a lot of scope for fraud, and entail enormous environmental costs.
The emergence of cryptocurrencies calls for global coordination to prevent abuses and to strictly limit inter-connections with regulated financial institutions.
The goal should be to ensure that cryptocurrencies cannot undermine the role of central banks as trusted stewards of monetary and financial stability.
The decentralised technology of cryptocurrencies, however sophisticated and useful for many other purposes, is a poor substitute for the solid institutional backing of money through independent and accountable central banks.
In terms of goals for policy, Carstens said the first was to secure the progress made over the last decade.
Second, continue on the path of normalising monetary policy, and normalise gradually, with careful communication, while considering global spillovers and spill-backs.
Third, maintain a long-term perspective and limit the build-up of imbalance s as part of the design and implementation of holistic macro-financial stability frameworks.
Finally, redouble efforts to implement structural reforms to strengthen the global economy's resilience and growth potential.
"In sum, we must seize the day. Addressing vulnerabilities is key to keeping the growth momentum on track. The stronger performance gives us a window to pursue necessary reforms and re-calibrate policies. Let's not miss this opportunity."
[* Chakravarthi Raghavan is the Editor Emeritus of the SUNS.]