by Chakravarthi Raghavan

Geneva, 5 June 2000 -- "Efficiency is not everything. Fairness and perceptions of fairness must also be taken into consideration."

Fasten seat belts and hold your breath. These are not words from the "extreme critics" of globalization that took to the streets at Seattle and Washington, but which "have already been debunked," the WTO claimed in its annual report last month. They are not even from UNCTAD and its Trade and Development Reports.

These are among the policy conclusions in the annual report of the Basle-based Bank of International Settlements (BIS), the central bank of the central banks of the world. Posing the question as to what policy-makers could do to ensure that the global economy reaps the benefits of a more efficient production and financial structure over time, the BIS says that whatever the answer "it must be recognized that efficiency is not everything."

"Fairness and perceptions of fairness must also be taken into consideration. Thus, issues of income distribution, debt relief and the protectionist policies of industrial countries, particularly towards imports of agricultural products and textiles from emerging markets, need more efficient attention than they have received thus far.

"A further constraint on the pursuit of efficiency, particularly in the development of financial systems, must be considerations of safety and stability. The potential economic costs of sporadic financial crises must always be weighed against the ongoing benefits of freer capital markets. Unless policy measures can adequately trade off all these competing objectives, a sharp and unwelcome turn away from a market-based approach to less desirable solutions cannot be ruled out."

But while injecting some sobering thoughts on need for policy measures to ensure fairness and income-distribution at a global level, the BIS report steers away from similar policy measures at national levels to balance liberalism with state intervention to produce domestic perceptions of fairness in income-distribution and benefits.

There is a widespread perception, says BIS, that the global economy now stands on the brink, but the brink of what remains the question. The better than anticipated recent economic performance in many parts of the world has predictably led both private and public sector bodies to revise their growth forecasts upwards. Many now see better economic prospects than at any time since the early 1980s. A prolonged boom in a more market-driven world economy could by no means be ruled out.

Yet, even if this longer-term vision is accepted, policymakers can still expect a few bumps along the way, says BIS. The rapid credit expansion of the last decade in many economies, a growing appetite for risks among lenders, the rise in concentration ratios in financial markets and the noticeable fall in liquidity -- all imply "not only that the global economy may have become more exposed macroeconomic shocks, but also that the dynamic response of markets to the shocks may be harder to predict than in the more regulated past."

And in a more globalised financial system, do policy-makers have all the tools required both to avert problems and to manage them should they arise. "This," the BIS adds, "is never an easy task since liquidity injections, which may be needed to help manage one crisis, can also encourage imprudent behaviour, simply leading to the next."

But the potential interactions between the principal macro-economic vulnerabilities -- stock prices still high by historical standards in many countries, and the stronger US dollar than is compatible with stabilisation of longer-term external debt ratios -- makes the possibility of a simultaneous adjustment in both equity and foreign exchange markets seem greater than historical correlations might indicate. This could mean slower demand due to wealth effects and rise in inflation due to internal and external pressures.

As a result, warns the BIS "neither a hard nor a soft landing could logically be ruled out", and in such an uncertain macroeconomic environment, an outflow of capital from emerging market economies might also be anticipated. "While those countries that now have current account surpluses and large external reserves might be little affected, not all emerging markets currently enjoy such a comfortable position."

Markets have viewed higher policy rates as helpful in sustaining economic growth while heading off inflation. Growth has been positive for stock prices and for credit spreads, and low inflation has perhaps constrained upward movement in bond rates.

"Yet, if the authorities were suddenly judged to be 'behind the curve', this could all go into reverse, with potentially contractionary effects," says BIS.

In addition, equity price movements could be exaggerated by the growing use of leverage and margined debt, portfolio insurance strategies and the increased dependence of blue-chip profits on stock gains in the high-tech area -- "all interwoven elements with potential for mischief."

Similarly, fixed income markets might also react uncharacteristically, given the changing status of benchmarks in both the US and European bond markets, and the growing reluctance of large firms to commit capital to a market-making function.

How any or all of these developments might feed back on to the health of individual financial institutions is another open question. A combination of continuing deregulation, heightened competition, technological change and increased concern for shareholder value may have encouraged behaviour and cross-sectoral relationships which will prove to have been imprudent only when the next downturn comes.

However, it must also be noted that financial markets have recently been extremely volatile, without any such knock-on effects, and very high volumes of financial transactions have been processed without any signs of strain.

Referring to the various imbalances in the global economy, the BIS notes that one point on which virtually everyone would agree is that the current rate of expansion of domestic demand in the USA is unsustainable and potentially inflationary, and that a similar if less extreme state of affairs prevails in some of the other English-speaking countries. BIS welcomes the recent trend towards monetary tightening is most welcome even if some asset prices currently look quite vulnerable.

But were monetary policy to back off at the first signs of declining equity prices, "the risks of moral hazard would be great."

"In any event, if the world has really entered a 'new era', the likelihood of a sharp and sustained reaction in equity markets would be much reduced. And if we have not, then it could be argued that the sooner the bubble deflates, the better."

This did not mean that a significant reaction in the stock market or more generally in financial markets should not elicit a measured policy response, since disinflation could go both too far and too fast. This danger was not insignificant in the US nor in a number of other countries advanced in the cycle. Given recent low rates of saving and heavy investment in housing and durable goods, it would now be very easy to postpone prospective expenditures.

"But once it has become apparent that certain investments will never yield their expected rates of return, the misguided investors should be allowed to pay the price, and quickly, so that capacity can be reduced and long-term profitability rapidly restored. This may be the principal lesson from the 1990s in Japan."

Another area of more or less universal agreement is that the rate of growth of private expenditures in Japan is too low. But an unresolved question is how it might be encouraged to quicken.

Japanese fiscal authorities should be commended for having been prepared to use fiscal policy counter-cyclically, though it could have been done more effectively.

While rising levels of public debt in Japan imply that overall fiscal stimulus would have to be more restrained in the future, a rebalancing of expenditures could pay big dividends, says BIS.

"Cutting back on the overdeveloped public investment side and increasing expenditures on the under-developed social safety net could help preserve needed confidence, and help increase labour mobility. And with old industries still plagued by over-investment, expansion in other areas must be encouraged through deregulation and related public policies."

As for continental Europe, the primary challenge is structural reform. Major macro-economic imbalances of the sort that increasingly confront the US and Japan are neither evident nor in prospect. Current account imbalances for the region as a whole do not pose a problem. Equities still constitute only a small proportion of house-hold wealth.

And, while the continuing weakness of the euro clearly has the potential to raise inflationary pressures, "a forward-looking and vigilant monetary policy would seem sufficient to allay most concerns."

Fiscal restraint might also be recommended in some smaller European economies already pushing the limits of potential, but in most countries policies of restraint have already been in place for some time.

But all of these macro-economic prescriptions for holding a steady course presume that the current European expansion will continue uninterrupted by dramatic events elsewhere.

Over the last few years, exchange rate movements among major currencies have generally provided support for cyclical stabilization. Recently however the strength of the yen and the persistent weakness of the euro have been less consistent with domestic objectives raising the question of what might be done about it, aside from policy rates. "The current answer appears to be, not much. However, circumstances could conceivably change."

Unilateral intervention by the Japanese has the disadvantage that its signalling function has limited credibility. Bilateral intervention with European involvement has been eschewed, even though potentially it would seem useful in the right market conditions. As for multilateral intervention involving the US, concerns have been expressed that this might be interpreted as a harbinger of managed global exchange rate system, for which currently there seems to be little official enthusiasm.

Looking further ahead, says the BIS, the biggest policy challenge could be coping with a sudden reversal in the fortunes of the dollar. The additional deflationary impact on Japan could be clearly unwelcome, though much less so in Europe where inflationary concerns have mounted. However even in Europe problems could arise if a rebound of the euro went too far and too fast.

The exchange rate issues loom even larger from the perspective of the emerging market economies - "as they are relatively more open and even more prone to sentiment-driven swings in capital flows."

For the moment, notes BIS, prospects of improvement economic performance in Asia, Latin America and eastern Europe have encouraged inflows, of direct investment in particular. "Nevertheless, concerns remain that external shocks or internal policy failures could suddenly put those flows into reverse.

Current account deficits and structural fiscal problems are potential worries in Latin america, while a heavy dependence on the technology sector and slow progress in corporate and bank restructuring may pose risks in Asia. Although emerging markets nominally have floating exchange rates, it is also true that many, especially in Asia, have been intervening heavily to stop a loss of competitiveness through current appreciation.

While touted as being consistent with need to build reserves, and better than capital controls, which have evoked surprisingly little interest to date, such policies could eventually lead to excessive credit creation, and just another way to lose competitiveness.

Perhaps more pernicious is the danger that borrowers may revert to fixed exchange rate mentality and encouraged once again to borrow in foreign currency at lower costs. While this might seem unlikely in light of recent crises, "it is astonishing how quickly people forget even hard earned lessons".

Referring to alternate policy regimes, including inflation targeting regimes, such as those adopted over the last year by South Africa, Brazil, Poland and the Czech Republic, BIS notes that among its advantages would be potential transparency, and the possible anchor provided for inflation expectations in countries, as in Latin America, with a particularly poor track record for controlling inflation.

But in targeting inflation, emerging market economies face some offsetting disadvantages as well -- including poor capacity to undertake sophisticated economic forecasting, unreliable data and problem of ongoing structural change.

In addition, many emerging markets, most recently in Asia, have proved vulnerable to asset price bubbles, not easily handled in an inflation targeting framework. And with food and imports making up such a large part of the consumption basket, and price deregulation often pervasive and ongoing, this may drive a significant wedge between headline inflation and the index that central bank actually feels it has a chance of controlling.

"The upshot is that emerging market countries face a sharply exaggerated version of the trade-off confronting industrial countries that target inflation: if they set their targets too ambitiously, they will lose credibility, if targets are missed; if they set more realistic goals, these may be judged too unambitious and the regime will enjoy no credibility.

"As with all regime choices, no one size fits all. Each country must look at its own circumstances and its own history and make a judgement about the best course to take. When it comes to the need for sound fiscal policies, no exercise of judgement is needed. Without such policies, history teaches us that any regime aimed at controlling inflation is doomed to failure." (SUNS4681)

The above article first appeared in the South-North Development Monitor (SUNS) of which Chakravarthi Raghavan is the Chief Editor.

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