TWN Info Service on Finance and Development (July11/01)
4 July 2011
Third World Network

BIS urges tighter monetary policy, rise in interest rates
Published in SUNS #7178 dated 28 June 2011
Geneva, 27 Jun (Chakravarthi Raghavan*) - The Bank for International Settlements (BIS) has called for a worldwide tightening of monetary policy and raising of interest rates, pointing to evidence of dwindling economic slack and rising food, energy and other commodity prices and the consequent rising inflationary pressures.

The BIS has also pointed to the new Basel III global standards for banks and financial institutions, and the ongoing and yet-to-be completed work on identifying and putting in place special guidelines and measures for the Systemically Important Financial Institutions, as also quick actions by national authorities in enacting laws for these standards, and stricter enforcement of these standards by regulatory authorities.

The Basel-based BIS, commonly called the central bank for the world's central banks, has given the call for monetary tightening and rising of interest rates in its 81st annual report released Sunday, and in the speech of its General Manager Jaime Caruana at the annual general meeting also on Sunday.

In promoting a tightening monetary policy and rise in interest rates, the BIS says: "Over the past year, the global economy has continued to improve. In emerging markets, growth has been strong, and advanced economies have been moving towards a self-sustaining recovery."

While in the halls of the world's high finance the world economy and recovery looks brighter, for the man-in-the-street, this may be hard to reconcile with the announced data of continued high unemployment in the advanced economies - over 9% in the US, a 17-year high of 7.7% of the economically active population in the UK, and over 10% as of October 2010 in Europe, according to Eurostat official data. And in the crisis-ridden Euro periphery (Greece, Portugal and Spain), the unemployment rates are also rising. And with it, countries face social problems, and threats of disorders, that governments have to cope with.

Central banks need to start raising interest rates to control inflation, and may have to move faster than in the past, the BIS said, adding: "Tighter global monetary policy is needed in order to contain inflation pressures and ward off financial stability risks... Central banks may have to be prepared to raise policy rates at a faster pace than in previous tightening episodes."

With interest rates having been raised in several of the emerging market economies in Asia and Latin America, unlike in the US, UK and Japan where the central banks are still engaged in a stimulative economic policy stance, the BIS message seems to be specifically addressed to the advanced industrial economies.

In his speech to the annual general meeting Sunday at Basel, Caruana stressed the need to normalise monetary policy, and said the prevailing, extraordinary accommodative policy rates will not deliver lasting monetary and financial stability. Real short-term interest rates, he noted, may have actually fallen in the past year from minus 0.6% to minus 1.3% globally.

The BIS report has directed particular criticism at the Bank of England's monetary policy committee (MPC) for maintaining UK interest rates at their current low level of 0.5% since March 2009.

"In the United Kingdom," the report says, "CPI inflation had exceeded the Bank of England's 2% target since December 2009, reaching a peak of 4.5% in April 2001 (in part due to an increase in the VAT). As yet there is no move by the MPC (to raise rates), but one wonders how long its current policy can be sustained."

In his speech Sunday, Caruana has referred to the excess capacity in finance and real estate sectors as pointing to the unfinished adjustments in the crisis-stricken economies. While the financial industry has built capital buffers, the "overall leverage in the economy, public and private, remains too high.".

Caruana adds: "The simple mean of household debt-to-GDP for the US, the UK and Spain has declined by only 2 percentage points from 2007 to end 2010, while for the same period and for the same countries, government debt-to-GDP rose by 30 percentage points."

Policymakers must intensify efforts to promote the repair of financial sector balance sheets, and set conditions for the long-term profitability of banks. The macroeconomic road ahead is likely to be as bumpy next year as it has been this year, he warns. Banks must be ready when the real shock inevitably comes, and tough stress tests, supported by recapitalisation measures are essential.

The BIS head also called for early completion of financial sector reforms, and full and consistent implementation worldwide of Basel III, and with higher standards for systemically important financial institutions and credible mechanisms for their orderly resolution.

In parallel meetings and actions last week at Basel (where the Basel Committee on Banking Supervision - BCBS - held meetings), central bankers and regulators have agreed to impose an extra capital charge of one to 2.5 percent of risk-adjusted assets on the largest banks in order to protect them from big losses that could trigger another meltdown.

The US and UK have been pushing for about 30 "global systemically important financial institutions" to carry additional capital.

The compromise deal forged at Basel now involves slightly smaller surcharge, but capital made up purely of equity. The surcharge will be over and above the 7% set last year for all banks under Basel III.

According to the Financial Times, this means about eight of the world's biggest and most inter-connected banks have to maintain top quality "core tier one capital" equal to 9.5% of their risk weighted assets by 2019, while another 20 more banks will face total ratios of 8-9%.

The BCBS has said that it reserved the right to impose a further surcharge of 1% or a total of 10.5% on the top banks, if they become bigger and more important to the banking system.

The world's big banks have been engaged in heavy lobbying of their own central banks, and the BCBS for lower capital ratios and/or wider range of capital (rather than pure equity). While they did not prevail at the BCBS (whose standards are guidelines to be implemented by national authorities), the banks are turning their attention to national regulators and legislators.

In the US, for example, of the 380 rules under the Dodd-Frank Act, supposed to have been written and enforced by next month, only 30 have been finalised. The rules for the biggest and most contentious areas - including regulation of derivatives and their trading, the identification and naming of the "too big to fail" institutions are all in flux.

Perhaps even more, according to media reports and reputed financial weblogs like ‘Naked Capitalism', the US Commodity Futures Trading Commission Chair, who sought modest additional funds from Congress for carrying out the new mandate (of policing the over $300 trillion of over-the-counter derivatives trading market and the enforcement of regulations), is now finding himself facing budget cuts of 15% on the CFTC's current budget.

The heavy lobbying by Wall Street firms to ensure lax enforcement of new regulations has presumably paid off.

In its annual report, BIS notes that while over the past year, the global economy has continued to improve - with strong growth in emerging markets, and advanced economies have been moving towards a self-sustaining recovery, it would be a mistake for policymakers to relax.

The numerous legacies and lessons of the financial crisis require attention. In many advanced economies, high debt levels still burden households as well as financial and non-financial institutions, and the consolidation of fiscal accounts has barely started. International financial imbalances are re-emerging.

Highly accommodative monetary policies are fast becoming a threat to price stability. Financial reforms have yet to be completed and fully implemented. And the data frameworks that should serve as an early warning system for financial stress remain underdeveloped.

The interrelated imbalances made pre-crisis growth in several advanced countries unsustainable. Rapidly increasing debt and asset prices resulted in bloated housing and financial sectors. The boom also masked serious long-term fiscal vulnerabilities that, if left unchecked, could trigger the next crisis.

Warns the BIS: "We should make no mistake here: the market turbulence surrounding the fiscal crises in Greece, Ireland and Portugal would pale beside the devastation that would follow a loss of investor confidence in the sovereign debt of a major economy."

Addressing over-indebtedness, private as well as public, is the key to building a solid foundation for high, balanced real growth and a stable financial system. Private savings have to be driven up, and substantial action taken now to reduce deficits in the countries that were at the core of the crisis. The lessons of the crisis also apply to emerging market economies. Those economies where debt is fuelling huge gains in property prices and consumption are running the risk of building up the imbalances that now plague the advanced economies.

Global current account imbalances are still with us, bringing the prospect of disorderly exchange rate adjustments and protectionism. The imbalances extend beyond current accounts to gross financial flows, which today dwarf the net movements commonly associated with the current account. And they pose perhaps even bigger risks by giving rise to potential financial mismatches and facilitating the transmission of shocks across borders. Not only that, but cross-border financing makes rapid credit growth possible even in the absence of domestic financing. As shown by the experience of the past few years, a reversal of strong cross-border capital flows can inflict damage on financial systems and on the real economy.

The imbalances in current accounts and in gross financial flows are related and need to be addressed together. Sound macroeconomic policies will play a key role in this regard, as will structural domestic policies to encourage saving in deficit countries and encourage consumption in surplus countries. Although the adjustment of real exchange rates is also required, it will not, by itself, be enough.

Countries will need to implement policies that strengthen prudential frameworks and the financial infrastructure. Capital controls that can offer only temporary relief should at best be the last resort.

While adjustment by surplus and deficit countries is necessary and mutually beneficial, it is constrained by a fundamental problem: countries may find unilateral adjustment too costly. This means that international coordination is essential to break the policy gridlock.

This call for international coordination is noteworthy in that not too long when it was the emerging economies that faced adjustment problems, they were asked to tighten their belts and bear it - without any actions by the advanced economies which were in surplus. However, this is perhaps in the nature of power and the control of big international institutions by the advanced economies and their power structures.

On monetary policy, the BIS says that the challenges are intensifying even as central banks extend the already prolonged period of accommodation. The persistence of very low interest rates in major advanced economies delays the necessary balance sheet adjustments of households and financial institutions, and magnifying the risk that the distortions that arose ahead of the crisis will return.

"If we are to build a stable future, our attempts to cushion the blow from the last crisis must not sow the seeds of the next one."

With the end of unconventional policy actions in sight, central banks face the risks associated with the resulting large size and complexity of their own balance sheets. Failure to manage those risks could weaken their hard-won credibility in delivering low inflation, as could a late move to tighten policy through conventional channels.

As the central bank of the world's central banks, the BIS report makes a strong pitch for independence of central banks, meaning independence from the executive and the legislative organs of state. However, given the way the major financial firms have a major voice in leading central banks like the US Fed and its regional Fed's and their own roles in contributing to the financial crisis, it would be a difficult exercise.

In a chapter of the report addressing data problems, the BIS says that the recent financial crisis revealed gaps in both the data and the analytical frameworks used to assess systemic risk. These gaps hampered policymakers in their efforts to identify and respond to vulnerabilities. To do their job, authorities need a broader and more accurate view of the financial system from multiple vantage points. That picture would show sectoral balance sheets and their global inter-linkages, and it implies a wider sharing of institution-level data within and across jurisdictions.

"While better data and analytical frameworks will not prevent future crises, experience suggests that the improvements will enable policymakers and market participants alike to identify vulnerabilities previously unseen and pick up the emergence of others much sooner."

The BIS thus joins a long list of institutions facing data problems that the UN statistical systems have not addressed or found solutions to: there is lack of data to assess value of trades in services in four modes of delivery, 17 years after the Marrakesh treaty, including its GATS framework, was concluded, and 25 years after the data problem was identified and the statistical system was asked to come up with answers, but with the manual adopted in 2000 for gathering statistics unable to give relevant data even now.

According to the WTO, there is also a lack of data on value-added in international trade as a result of which there is double or multiple counting of gross trade values in production and trade across countries, creating tensions and protectionist pressures in the multilateral trading system. The intra-industry trades, and value-added in such trades, and its rapid growth and sizeable share in international trade was identified by Paul Rayment in the 1980s, and followed up by the UN-ECE and UNCTAD in the 1990s, but global finance and trading systems ignored it till now, and so have the statisticians and the global statistical systems.

While a new attitude and optimism is gaining a foothold in advanced economies, the BIS cautions against slackening on the major tasks in repairing the system. "The sooner advanced economies abandon the leverage-led growth that precipitated the Great Recession, the sooner they will shed the destabilising debt accumulated during the last decade and return to sustainable growth. The time for public and private consolidation is now."

Over the past year, says BIS, with growing confidence that the recovery had become self-sustaining, market participants had been gradually resuming their willingness to take on risk, as would be expected in the early stages of a cyclical upturn. However, there has been the related development of resurgence of financial innovation, with strong growth in new instruments and vehicles such as synthetic exchange-traded funds, commodity-linked notes and commodity-based hedge funds.

While the return of innovation is a positive sign, the arrival of new products with risks untested by market stress, "poses an important challenge for authorities tasked with maintaining financial stability."

Over the past year, while there has been confidence in self-sustaining recovery and a sense of optimism, in the peripheral euro area countries, the fiscal problems have already sapped investor confidence to the point where sovereign borrowing costs have soared beyond sustainable levels. For well over a year, European policymakers have been scrambling to put together short-term fixes for the hardest-hit countries while debating how to design a viable and credible long-term solution. "They need to finish the job, once and for all," BIS says.

While the fiscal woes of a number of euro area countries have resulted in eye-popping jumps in their sovereign bond yields and CDS (credit default swap) spreads, other mature sovereigns with record high fiscal deficits and outsize levels of public debt have not seen any market effects. Countries with lower private debt seem to have more capacity to repay their public debt, and there may be a greater willingness to repay, when public debt is held by domestic residents.

"Also, having an independent currency and monetary policy seems to play a role, as this provides policymakers with greater flexibility."

A loss of confidence in the ability and willingness of a sovereign to repay its debt is more likely to be characterised by a sudden change in sentiment than by a gradual evolution, and governments that put off addressing their fiscal problems run a risk of being punished both suddenly and harshly.

Hence, fiscal authorities must take swift and credible action to bring debt levels down to sustainable levels. This requires both short-term measures to reduce deficits in the aftermath of a costly recession, and addressing longer-term challenges arising from structural imbalances. In many countries, this involves facing up to the fact that, with their populations ageing, promised pension schemes and social benefits are simply too costly to sustain.

Simply returning to the pre-crisis fiscal stance will not be enough. Fiscal positions preceding the financial crisis were made to look unrealistically rosy by the tax revenues arising from unsustainable credit and asset price booms. Cyclical surpluses need to be built up as buffers that can be used for stabilisation in the future, and for this, governments need a reserve fund. Merely running a cyclical balance, in which budget surpluses in booms neutralise budget deficits in recessions, is not good enough.

The risk of aggressive austerity measures choking off economic growth, in advanced economies, where the recovery appears now to be self-sustaining, is much smaller than it was a year ago. In most emerging market economies, it is almost nonexistent.

But more importantly, in a number of cases the long-run fiscal outlook has not improved, at least not enough. The unavoidable conclusion is that the biggest risk is "doing too little too late" rather than "doing too much too soon".

Cautioning against impeding cross-border capital flows or financial integration that facilitates them, BIS argues that some of their harmful side-effects is best targeted by making structural domestic adjustments, improving international policy coordination and strengthening the financial stability framework. What is needed are policies in deficit countries to encourage saving and policies in surplus countries to encourage consumption. And although not enough by themselves, changes in real exchange rates are also essential; however, major countries resist real exchange rate adjustment.

This policy gridlock must be broken by international coordination that would distribute the burden of adjustment across major surplus and deficit countries. Without such cooperation, the outsize current account imbalances, the large net financial flows they generate and the resulting vulnerabilities will continue to grow.

As for gross capital flows, the principal defence against the risks posed by them is a set of macroeconomic policies that promote monetary stability and fiscal sustainability. Regulatory and macro-prudential measures play a secondary role, while, as a last resort under extraordinary conditions, capital controls can serve as a stopgap measure.

In terms of regulatory reforms, the BIS report notes that the reforms in Basel III include requirements for both a higher minimum quantity of capital and a better quality of capital to cover more risks, as also additional capital buffers that will be adjusted counter-cyclically to limit the amplitude of credit cycles, and new liquidity standards - holding sufficient liquidity to be able to weather a variety of shocks.

However, the work is not finished, and significant challenges remain. Among them is the need to ensure that systemically important financial institutions (SIFIs) become, in effect, less so. This means first figuring out which institutions are systemically important and then determining the steps needed to make them sufficiently resilient.

Regulators are busy working out how much additional loss absorbency global SIFIs should have. Moreover, while the Financial Stability Board (FSB) has issued recommendations for enhanced supervision of SIFIs, the details still need to be settled by national supervisors, standard setters and the FSB. This process is complicated by the existence of various types of SIFIs. For example, among SIFIs, an insurance company would probably have balance sheet risks that need to be treated differently from those faced by a bank.

Another key to building the foundations of a stable financial system is to extend the regulatory perimeter beyond traditional financial institutions to cover shadow banks - entities that perform maturity or liquidity transformation outside the currently regulated banking system.

Shadow banks have the potential to generate substantial systemic risk because they can be highly leveraged and engage in significant amounts of maturity transformation while being closely linked to commercial banks. And, as the name suggests, the shadow banks can do all of this in ways that are less than completely transparent.

Banks - often systemically important ones - typically generate large profits by sponsoring shadow banking activities to which they have significant direct and indirect exposures, including backup lines of credit and various sorts of credit enhancements.

It is exactly that linking of the banking system to the shadow banks, including explicit or implicit guarantees to the holders of shadow bank liabilities, that gives rise to some of the most pernicious financial stability risks. By comparison, mutual funds and hedge funds, although huge in terms of the money involved, pose less of a systemic risk because they are generally less leveraged and have fewer and looser ties to banks.

Aside from completing the preparation of the new global standards, it is essential that national authorities translate them into legislation and regulations in a timely and globally consistent manner. Financial stability will be jeopardised by any attempt to delay or weaken the agreements.

Finally, even after their implementation, the new rules, as such, will not be sufficient: rigorous enforcement by supervisors within and across national boundaries will play a key role in making sure that financial institutions comply with them.

(* Chakravarthi Raghavan is the Editor Emeritus of the SUNS.)