TWN Info Service on Finance and Development (July10/01)
5 July 2010
Third World Network

Emergency room to intensive care and, recovery or relapse?
Published in SUNS #6954 dated 29 June 2010

Geneva, 28 Jun (Chakravarthi Raghavan*) -- The Bank for International Settlements (BIS), commonly described as the "central bank of the world's central banks", has come down firmly on the side of those arguing for a rise in interest rates, even though industrial countries are facing a fragile and uneven recovery.

In its 80th annual report published Monday, the BIS, holding its annual general meeting in Basel, also came down on the side of those pressing fiscal consolidation and reducing the burgeoning fiscal deficits.

The report, which went to press between 7-11 June, appears to have been clearly written before the onset of the issue of the sovereign debt crisis in Europe and the euro zone.

The BIS recommendations run counter to what emerged at the G20 summit that was held over the weekend in Toronto (Canada), where China and the emerging economies supported the US against a premature end to stimulus, while Europe pushed for fiscal consolidation and a start to cutting fiscal deficits. The G20 gathering compromised with a declaration where all countries agreed to halve their deficits by 2013 and stabilise the ratio of debt to gross domestic product by 2016 (see separate article).

The BIS views on monetary policy, and a start to raising interest rates, are in its annual report where it surveys what has happened in various countries when interest rates were held low for relatively long periods of time - building up asset bubbles in housing and real estate that burst, seizing credit markets, hitting financial institutions and requiring unorthodox central bank and treasury actions to rescue them - and with serious consequences to the real economy including continuing high unemployment.

While policymakers need to use other tools to address some of the risks, the BIS says "they may still need to tighten monetary policy sooner than consideration of macroeconomic prospects alone might suggest".

Long periods of low interest rates, the BIS notes, induces banks to indulge in what it calls "evergreening" - the practice of rolling over debt to non-viable businesses that can continue making interest payments at low rates but cannot afford to repay the principal. This delays the necessary restructuring not only of the financial sector but also of the other inefficient industries.

It also notes that low interest rates may inadvertently contribute to instability in financial institutions, which in spite of massive government interventions, remain fragile.

"Cutting interest rates to record lows was necessary to prevent the complete collapse of the financial system and the real economy," the BIS says, "but keeping them low for too long could also delay the necessary adjustment to a more sustainable economic and financial model."

Overall, the BIS has presented a sombre picture of the daunting legacy of the financial crisis facing policymakers, especially in industrial countries - having to cope with a fragile and uneven recovery, and a fragile financial system where a shock of virtually any size risks a replay of the events of the late 2008 and early 2009, but with hardly any room for manoeuvre.

In an opening chapter headed, "Beyond the rescue: exiting intensive care and finishing reforms", BIS says: "Three years after the onset of the crisis, expectations for recovery and reform are high but patience is wearing thin. Policy-makers face a daunting legacy: the side effects of the ongoing financial and macroeconomic support measures, combined with the unresolved vulnerabilities of the financial sector, threaten to short-circuit the recovery and the full suite of reforms necessary to improve the resilience of the financial system has yet to be completed."

ln setting policies, industrial countries must adopt a medium- to long-term perspective while they cope with the still fragile and uneven recovery. Households have only just begun to reduce their indebtedness and therefore continue to curb spending. Extraordinary support measures helped to contain contagion across markets, preventing the worst. But some measures have delayed the needed adjustments in the real economy and financial sector, where the reduction of leverage and balance sheet repair are far from complete. All this continues to weigh on confidence. "The combination of remaining vulnerabilities in the financial system and the side effects of ongoing intensive care threaten to send the patient into relapse and to undermine reform efforts."

Unprecedented macroeconomic policies accompanied the large array of direct actions to support the financial system. But such macroeconomic support has its limits, and recent market reactions demonstrate that the limits to fiscal stimulus have been reached in a number of countries. "Immediate, front-loaded fiscal consolidation is required in several industrial countries," but such policies need to be accompanied by structural reforms to facilitate growth and ensure long-term fiscal sustainability.

ln monetary policy, despite the fragility of the macro-economy and low core inflation in the major advanced economies, keeping interest rates near zero for too long, with abundant liquidity, leads to distortions and creates risks for financial and monetary stability.

Fundamental reform of the financial system must be completed to put it on more stable foundations to support high sustainable growth for the future, and the reforms should produce more effective regulatory and supervisory policies as part of an integrated policy framework. A new global framework for financial stability should bring together contributions from regulatory, supervisory and macroeconomic policies. Supported by strong governance arrangements and international cooperation, such a framework would promote the combined goals of financial and macroeconomic stability.

The financial disruption in the first half of 2010 have brought the fragility of the industrial world's financial system into stark relief: a shock of virtually any size risks a replay of the events seen in late 2008 and early 2009. The sovereign debt crisis in Greece is clearly jeopardising Europe's nascent recovery from the deep recession brought on by the earlier crisis.

Unlike then, however, there is hardly any room for manoeuvre. Policy rates are already at zero and central bank balance sheets are bloated. Although private sector debt has started to decline, public debt has taken its place, with sovereign fiscal positions already on an unsustainable path in a number of countries.

In short, macroeconomic policy is in a vastly worse position than it was three years ago, with little capacity to combat a new crisis - it will be difficult to find a source of further treatment should another emergency arise. Regaining the ability to react to economic and financial crisis, by putting policies onto sustainable paths, is therefore a priority for macro-economic policy.

For fiscal policy, the sizeable fiscal consolidation needed urgently in a number of industrial countries should generally take two forms: reductions in current deficits and action that ensures long-term fiscal sustainability. For monetary policy, the fragility of the macro-economy may be delaying tightening.

But policymakers should not lose sight of the risks to financial and macroeconomic stability arising from a long period of very low interest rates. The side effects will continue to cumulate - eventually reinforcing precisely those factors that contribute to the fragility of the financial systems and made it crisis-prone in the first place.

Finishing the reforms to the financial system, particularly those that will quickly increase its resilience, has acquired even greater urgency. They can provide the most immediate protection to the financial system in the event of a new crisis. Moreover, acting now to improve the capital base and the liquidity of bank balance-sheets will not jeopardise the recovery. Rather - by making financial institutions sounder - those actions will promote a sustainable recovery.

Those efforts will bring us closer to the long-term goal of making future crises less likely and less severe.

Finishing that job means tackling remaining reforms without delay: implementing an impermeable regulatory perimeter for all systemically important financial institutions, addressing systemic weaknesses in financial market infrastructure and instruments, and integrating financial stability concerns in macroeconomic policy frameworks.

[At Toronto, the G20, while supporting continued reforms of the banking sector and requiring banks to have higher capital and liquidity provisions (as is being proposed by the Basel Committee on Banking Supervision), has however in effect ceded to the pressures from banks by extending the time period for compliance.

[In the United States, where the House and Senate Conference Committee completed last week work on the proposed Dodd-Frank act, described as the largest overhaul of Wall Street since the 1999 Gramm-Leach-Bliley Act (that repealed the last vestiges of the Glass-Steagall Act), the reform bill from the conference committee has still to be adopted by the House and the Senate - where Democrats still need the votes of two or three Republicans to muster the 60 votes needed to overcome the threat of a Republican filibuster.

[Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the banking committee who with Representative Mr. Barney Frank led the negotiations, said the bill would prevent the corporate bailouts required in 2008 and allow the United States to become a global leader in financial regulation, potentially providing decades of stability. But he acknowledged that the effectiveness of the legislation would be learned only over time, and ""We won't know until we face the next economic crisis."]

While some emerging market economies are in danger of overheating, GDP in most advanced economies is still well below pre-crisis levels despite strong monetary and fiscal stimulus. The rapid increase of government debt raises urgent questions about the sustainability of public finances. Banks have increased their capital buffers, and profits have been boosted by a number of temporary factors.

But banks still remain vulnerable to further loan losses. As recent disruptions in funding markets have shown, banks can face significant refinancing pressures when sentiment turns adverse. Although banks in the crisis countries have made some progress in repairing their balance sheets, this process is far from complete. Efforts to restructure and strengthen the financial system should continue.

In other recommendations, the report also underlines that the crisis has brought out that the business models of financial firms are seriously flawed - with firms earning comparatively low returns on assets but using high-leverage to meet targets for returns on equity, and using cheap short-term funding, making their profits more volatile.

The BIS calls for reforms requiring financial institutions to have higher prudential buffers and lower leverage to ensure structural resilience of the financial sector.

Emerging market economies (EMEs) are recovering strongly and inflation pressures there are rising. Given low policy rates in the major financial centres, many EMEs are concerned that their stronger growth prospects could attract destabilising capital inflows, leading to currency appreciation.

Some continue to keep policy rates low and resist exchange rate appreciation by conducting large-scale intervention in foreign exchange markets. Such policies tend to be associated with a sizeable expansion in bank balance sheets, rapid credit growth and asset price overshooting. The risks of domestic overheating thus increase.

To promote more balanced domestic and global growth, some EMEs could rely more on exchange rate flexibility and on monetary policy tightening. ln addition, prudential tools have an important role to play in enhancing the resilience of the financial system to domestic and external financial shocks. ln contrast, while capital controls may have a limited and temporary role, they are unlikely to be effective over the medium term, BIS says.

The BIS argues against using discretionary capital controls to deal with surges in inflows (favoured by many EMEs), on the ground that they can offer only temporary relief, and to the extent that they are effective, capital controls reduce competition in the financial system, distort the efficient allocation of capital and inhibit economic growth.

This appears to be more of an ideological bow to the discredited financial efficiency and rational market theories of the Chicago school that have been blown sky-high by the experience of the last three years and the "financial crises" that has required massive rescues and State interventions, with the tax-payers footing the bill.

(* Chakravarthi Raghavan is the Editor Emeritus of the SUNS, and contributed this review article.) +