TWN Info Service on Finance and Development (Jun07/03)

27 June 2007

BIS ADVOCATES RISE IN INTEREST RATES IN LEADING DEFICIT COUNTRIES

The world’s leading economies, and in particular the deficit countries, need to increase interest rates in order to avoid the twin risks of rising inflation and global trade imbalances, the Bank for International Settlements (BIS), has suggested.

In its annual report (April 2006 - March 2007) released Sunday, the BIS also advocated policies in surplus countries, in particular Japan and China, that would lead to the Japanese yen appreciating, as also for the Chinese renminbi to appreciate, even as the BIS recognised the problems it may create for China.

The BIS report noted that global growth was strong along with subdued inflation – broad-based growth upswing in the industrial countries, continued rapid growth in emerging market economies, and with poorer countries too sharing in the growth. And the consensus forecast for 2007 and 2008 point to a continuation of these recent developments.

Real growth in the global economy, the BIS notes, has been maintained around levels that are among the highest recorded in the post-war period, and a welcome feature of this is that the world’s poorest countries have shared in this growing prosperity. In spite of this rapid growth, and significant upward shocks to commodity prices, underlying inflation levels have remained subdued. Real interest rates and risk premia of all sorts have remained uncharacteristically low. Record global trade imbalances have thus far been easily financed. And exchange rates have remained generally quite stable.

Below is a report of the BIS’ forecast of the global economy by Chakravarthi Raghavan, Editor Emeritus of the South-North Development Monitor (SUNS).

It was published in SUNS #6279 Tuesday 26 June 2007.

With best wishes
Martin Khor
TWN

BIS Advocates Rise in Interest Rates in Leading Deficit Countries

By Chakravarthi Raghavan

The world’s leading economies, and in particular the deficit countries, need to increase interest rates in order to avoid the twin risks of rising inflation and global trade imbalances, Mr. Malcolm Knight, the General Manager of the Bank for International Settlements (BIS), has suggested.

The Basle-based BIS, the central bank for the central banks of the world, is holding its annual meeting Monday at Basle, and preceding that over the weekend has been holding meetings with some 200-odd central bankers of the world. Knight spoke to the media Sunday at Basle, after his talks with the central bankers of the world, and on Monday addressed the annual BIS meeting.

In its annual report (April 2006 - March 2007) released Sunday, the BIS also advocated policies in surplus countries, in particular Japan and China, that would lead to the Japanese yen appreciating, as also for the Chinese renminbi to appreciate, even as the BIS recognised the problems it may create for China.

The BIS report noted that global growth was strong along with subdued inflation – broad-based growth upswing in the industrial countries, continued rapid growth in emerging market economies, and with poorer countries too sharing in the growth. And the consensus forecast for 2007 and 2008 point to a continuation of these recent developments.

In fact, the performance of the global economy over the last few years has been “extraordinary”, and the consensus forecasts of its likely continuance is such that it has the BIS and other central bankers worried over the uncertainties of downside risks and a combination of them acting together, “in a fundamentally uncertain world, in which probabilities cannot be calculated, – rather than simply a risky one.”

Real growth in the global economy, the BIS notes, has been maintained around levels that are among the highest recorded in the post-war period, and a welcome feature of this is that the world’s poorest countries have shared in this growing prosperity. In spite of this rapid growth, and significant upward shocks to commodity prices, underlying inflation levels have remained subdued. Real interest rates and risk premia of all sorts have remained uncharacteristically low. Record global trade imbalances have thus far been easily financed. And exchange rates have remained generally quite stable.

In isolation, each of these outcomes might be welcomed without further reflection. “However,” says the BIS, “the combination of developments is so extraordinary that it must raise questions about the source and, closely related, the sustainability of all this good fortune.”

“Economics is not a science, at least not in the sense that repeated experiments always produce the same results,” the report underlines in a sober opening to its concluding chapter. “Thus, economic forecasts are often widely off the mark, particularly at cyclical turning points, with inadequate data, deficient models and random shocks often conspiring to produce unsatisfactory outcomes. Even trickier is the task of assigning probabilities to the risks surrounding forecasts. Indeed, this is so difficult that it is scarcely an exaggeration to say that we face a fundamentally uncertain world - one in which probabilities cannot be calculated - rather than simply a risky one.”

Referring to economic history, and past events where commentators and analysts of the time were taken by surprise, the report cites the great inflation of the 1970s, and the subsequent disinflation and economic recovery, the great depression of the
1930s, the crises of early 1990s in Japan and Southeast Asia and micro-level surprises like the LTCM crises, and notes that even the argument that understanding of the economic processes has improved as a result of experience is not an easy proposition to prove.

Indeed, in the light of massive and ongoing structural changes, it is not hard to argue that our understanding of economic processes may even be less today than it was in the past.

Among other things, the report cautions policy-makers against dangerous financial innovation, especially distribution of credit risks through asset-based securities.

On the real side of the economy, a combination of technological progress and globalisation has revolutionised production. On the financial side, new players, new instruments and new attitudes have proven equally revolutionary. And on the monetary side, increasingly independent central banks have changed dramatically in terms of both how they act and how they communicate with the public. In the midst of all this change, no one could seriously contend that it is business as usual?

There is, moreover, a special uncertainty in the area of monetary policy – where central bankers in the pursuit of price stability are divided on the role of money and credit in the conduct of monetary policy.

Against this background, neither central banks nor the markets are likely to be infallible in their judgments. The implication for markets is that they must continue to do their own independent thinking. Simply looking into the mirror of the central banks’ convictions could well prove a dangerous strategy. The implication for policymakers is that they should continue to work on improving the resilience of the system to inevitable but unexpected shocks.

The consensus forecast for the global economy is that recent high levels of growth will continue, that global inflation will stay quite subdued, and that global current account imbalances will gradually moderate. As for financial markets, the consensus forecast for 2007 is that long rates will stay around current levels. Evidently, and appropriately, this forecast implicitly assumes that there will be no major geopolitical disruptions and no disturbances in the financial sector significant enough to affect the real economy.

As a near-term proposition, a forecast that says the future will be a lot like the past has much to recommend it. Looking closely at forecast errors in recent years, one might conclude that there are grounds for even greater optimism. Real growth has, on the whole, been stronger than expected, while inflation has generally stayed in line with predictions, despite sharp increases in commodity prices in the last year or so. Long-term interest rates have also consistently come in below anticipated levels. Since it is well known that forecast errors often display a significant degree of persistence, one might with some confidence expect the good news to continue.

Only with respect to global trade imbalances have the actual out-turns been markedly worse than expected, but even here, there are some signs of improvement.

Yet it is not difficult to identify uncertainties that could conceivably cause this near-term forecast to come unstuck, or that could result in less welcome outcomes over a longer horizon. The report while analysing separately the various areas of concern, cautions that they could well be interdependent - with the accommodative financial conditions as the causal thread linking these areas of concern together.

A first uncertainty has to do with the possible resurgence of global inflation and, potentially, inflation expectations. Estimates of capacity gaps in most of the major industrial countries indicate that they are approaching or have reached the limits of their potential. Disinflation pressures originating in emerging market economies also seem to be easing in the wake of sometimes extraordinary domestic growth rates. In China, in particular, it has become increasingly clear over the last few months that measures to slow the economy have not been effective so far. Partially as a result, continued strong increases in global energy and other commodity prices show no signs of abating, and questions are being raised about the ongoing capacity of companies to offset these higher costs through savings elsewhere. Finally, the fact that monetary and credit aggregates have also been growing very rapidly, not least in countries such as China that use foreign exchange intervention to resist currency appreciation, is a further worrisome sign for many.

In the US, the possible inflationary impact of cyclically rising wages and declining productivity growth is a source of near-term uncertainty. In addition, the ratio of house prices to rents is at an all-time high, and unless house prices fall significantly, a re-normalisation would imply a prospective rise in rents which would feed directly into the measured CPI. Moreover, if global trade imbalances need to be resolved, a further and perhaps substantial decline in the dollar might also be part of the adjustment process. To date, shrinking foreign margins, allied with productivity increases, have sufficed to keep exchange rate pass-through to a minimum in the United States. Whether this will continue remains to be seen.

Viewed in this light, the recent slowing in the US economy must be judged as welcome. Yet, there are concerns that this might turn into rather too much of a good thing.

While the attention of financial markets focused on the US subprime mortgage market, the underlying issue is much broader. The household saving rate in the United States fell for a time into negative territory. Easy credit terms, especially in the mortgage market, encouraged both higher debt levels and higher house prices. The latter, in turn, provided both the collateral to justify more lending, and the perception of increased wealth to justify more spending.

The concern is that this might all reverse. Debt service levels are already elevated and mortgage rates might rise further. House prices only need to stop rising (indeed, this may already have happened) to slow both the recourse to credit and the sense of confidence arising from increases in wealth. Moreover, when cuts in construction jobs begin to match the much larger fall in housing starts to date, then wage income, job security and confidence could be further affected. Were corporate fixed investment, already inexplicably weak given high profits and low financing costs, to retreat as well, then the stage might be set for a more significant and perhaps unwelcome deceleration in US growth.

Were the US economy to slow substantially, the crucial question would be how others might be affected. On the one hand, domestic demand has recently gained strength in the euro area and Japan, as well as in a number of emerging market economies. And unlike the IT-related slowdown around the turn of the century, there has not been a synchronised industrial boom that might suddenly collapse at the global level. Support for continued global growth is also provided by the falling share of exports to the United States, in a context of surging world trade overall.

On the other hand, in both Germany and Japan, the revival of domestic demand has been overwhelmingly in the form of corporate investment, itself driven by strong export demand. The same can be said for China, where the growth rate of the economy has been characterised by Premier Wen Jiabao as “unstable, unbalanced, uncoordinated and unsustainable”.

And, even without a synchronised business cycle, boardroom confidence globally might be affected by a sharp US downturn. And while direct exports to the United States might have fallen relative to global totals, a major component of the latter has been imports for assembly in China. In this regard, the indirect exposure of many countries in Asia to slower US growth might still be significant. Finally, the US is by no means alone in its dependence on debt-fuelled consumption, with some countries even having substantially negative household saving rates. This provides a further channel for possible contagion.

To near-term uncertainties about inflation and growth must be added a number of medium-term concerns, not least persistent and substantial global trade imbalances. Is this a problem, requiring a policy response to lower the possibility of large and perhaps abrupt movements in exchange rates? Or, is one to assume that the capital inflows needed to finance such deficits will be available on not significantly different terms for the foreseeable future?

Countries with large trade deficits are generally those where domestic demand has been growing relatively fast, and where interest rates are relatively high in consequence. In principle, such countries should also have depreciating currencies. This would allow external deficits to be reduced over time as domestic demand began to ease under the influence of higher rates.

Unfortunately, in practice, relatively high interest rates often induce private capital inflows of such a magnitude as to cause the exchange rate to appreciate rather than depreciate, and to raise domestic asset prices, which leads to more spending rather than less. Both these developments will cause the trade deficit to worsen further. This process was very much part of the story in the United States prior to 2001, and the second element of it continues today. Moreover, in recent years there have been a number of variations on this “carry trade” theme, with still more dramatic effects on smaller economies like New Zealand and a number of countries in central and eastern Europe. In many of these countries, including some where fundamentals have significantly improved, fears have been rising that a sudden reversal of such capital flows might significantly complicate macroeconomic management.

The US trade deficit is of a very special nature, largely because of the dollar’s role as a reserve currency. Thus, the significant reduction of private sector capital inflows after 2001 was counterbalanced by inflows from the public sector, leading to only a gradual decline in the value of the dollar. This has had the advantage of being quite manageable, but the disadvantage is that there has been no discernible reduction in the US trade deficit. When we add to this the gradual movement of the service account into deficit, and the growing size of the external debt position, the dollar clearly remains vulnerable to a sudden loss of private sector confidence, and presumably associated increases in risk premia in financial markets. While to some degree this would be welcome, as part of the external adjustment process, it could at the same time aggravate both near-term inflation pressures and the risks of a more serious downturn.

The reliability of public sector inflows has also become more uncertain, for at least two reasons. First, countries outside the United States might now be increasingly inclined to reduce intervention and let their currencies rise. The second potential threat is that holders of large portfolios of reserves might begin to reduce the proportion of new reserves held in US dollars. Also, as reserve managers increasingly focus on maximising returns, they will be attracted to the currencies of countries that give them ready access to equity and other instruments that allow them to do so.

A final set of medium-term uncertainties has to do with potential vulnerabilities in financial markets and possible knock-on effects on financial institutions. The prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003. While there are various explanations, the BIS warns that the market reaction to good news might have become irrationally exuberant. One manifestation of this has been that the intermittent periods of financial volatility have become progressively shorter, and this has encouraged the view that lower prices constitute a buying opportunity.

The danger with such endogenous market processes is that they can, indeed must, eventually go into reverse if the fundamentals have been overpriced. Moreover, should liquidity dry up and correlations among asset prices rise, the concern would be that prices might also overshoot on the downside. Such cycles have been seen many times in the past.

While big investment and commercial banks seem very well capitalised, and many have been making record profits, with unprecedented attention to risk management issues, there are also sources of concern: the spreads on credit default swaps for some of the best known names have recently been elevated in comparison to the levels that would be normal given their credit ratings. One area of concern is market risk and leverage. Balance sheets have grown significantly. Moreover, value-at-risk measures have stayed constant even though measured volatility has fallen substantially. Another possible worry, linked to the “originate and distribute” strategy, is that originators might be stuck with a warehouse of depreciating assets in turbulent times. The fact that banks are now increasingly providing bridge equity, along with bridge loans, to support the still growing number of corporate mergers and acquisitions, is not a good sign. A closely related concern is the possibility that banks have, either intentionally or inadvertently, retained a significant degree of credit risk on their books.

The risk is embodied in various forms of asset-backed securities of growing complexity and opacity - purchased by a wide range of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been encouraged to invest by the generally high ratings given to these instruments. Unfortunately, the ratings reflect only expected credit losses, and not the unusually high probability of tail events that could have large effects on market values. Hedge funds might be most exposed, since many have tended to specialise in purchases of the riskiest sorts of these instruments, and their inherent leverage can in consequence be very high.

By definition, it is not possible to put all these uncertainties together and arrive at a prediction. Behind each set of concerns lurks the common factor of the highly accommodating financial conditions. All this should serve to remind policy-makers that tail events affecting the global economy might at some point have much higher costs than is commonly supposed.

In terms of policy response, however, today’s evident good times must be used to prepare for a less certain future. In terms of fiscal policy, the BIS chief advocates policies aimed at further facilitating the shift of resources between tradable and non-tradable sectors in both surplus and deficit countries. Such a shift into non-tradable sectors is essential in countries with large trade surpluses - in particular Japan and China, says the BIS. By the same token, a shift into tradables is needed in the United States to help reduce its current account deficit.

However, in all these countries, allocation of resources at the moment is taking place in the wrong direction. In China and Japan, investment is still focussed on export markets. In the United States, it is the massive investment in housing that is unwelcome from an external adjustment perspective. Housing is the ultimate non-tradable, non-fungible, long-lived good.

The implication is that the price signals provided by exchange movements need to be significantly greater than otherwise.

In terms of the financial sector, it might be undesirable, even if it were possible, to rollback changes that have occurred over the last few years in the advanced industrial countries. Nevertheless, there must be scepticism about purported benefits of new players, new instruments and new business models, in particular, the “originate and distribute” approach.

And in emerging markets, “liberalisation needs to be preceded by structural changes that will allow financial systems to remain resilient in the face of both domestic and external shocks.” While much progress has been made, “much more is still needed.”

Though the BIS has not spelt this last out, it is a cautionary signal against the drive for liberalisation of financial markets and services being pushed at the IMF, by the new World Bank President designate, and in the financial services talks at the WTO.

As for central banks and supervisory authorities, in terms of monetary policy, BIS advocates gradual normalisation of level of policy rates - to contain any inflationary risks and collaterally help lean against any buildup of vulnerabilities in financial markets associated with underpricing of risks.

The BIS argues that in general, large economies with floating exchange rates should continue to let them float freely; there is clearly something anomalous in the ongoing decline in the external value of the yen. Tighter monetary policies would help to redress this situation, but the underlying problem seems to be a too firm conviction on the part of investors that the yen will not be allowed to strengthen in any significant way.

There should also be a greater willingness to let the renminbi rise, even though one recognises the formidable internal challenges this will pose to the Chinese authorities. Such a move would also allow other Asian currencies to move up further against the US dollar, again contributing to a reduction in global trade imbalances.

While some in China seem to believe that the source of Japan’s recent problems lay in allowing the yen to rise in the late 1980s, this is a misreading of history. The seeds of the Japanese bust were actually sown in the preceding, rampant monetary expansion designed to keep the yen down. Moreover, given the recent rates of credit expansion, asset price increases and massive investments in heavy industry, the Chinese economy also seems to be demonstrating very similar, disquieting symptoms.

In the area of prudential policy, authorities should redouble efforts to strengthen financial infrastructure - such as recent actions to improve confirmation and settlement of credit derivatives, strengthening of domestic capital markets in emerging markets, encourage prudential behaviour through supervisory review processes, and strengthening the macro-prudential orientation of regulatory and supervisory frameworks, as well as continuance of quiet efforts to improve mechanisms for addressing potential financial distress if it were to emerge.

And an increasingly globalized world puts a premium on close dialogue and cooperation among national authorities.

* Chakravarthi Raghavan is Editor Emeritus of the South-North Development Monitor (SUNS).