Everyone should look for "exit strategies", says BIS

by Chakravarthi Raghavan

Geneva, 7 June -- The worst of the crisis in emerging and financial markets seems to be over, further turmoil cannot be ruled out, warns the Bank of International Settlements (BIS), in its Annual Report published Monday.

In recent episodes of turmoil, the world has benefited materially from the continued strength of the US economy.

"However, exit strategies should now be the preoccupation for all prudent policy-makers, including those in the United States," the BIS says in a cryptic, 'read-between-the-lines" comment.

The recent dramatic events in many parts of the emerging world have made it clear that macroeconomic variables can be subject to extreme outcomes, and one should not suppose that advanced industrial economies are immune to such problems. The current difficulties remain deeply rooted in excessive capital formation and credit expansion, and significant imbalances remain within the global economy. And recent experiences show there can be "a darker side to the operation of a market economy, particularly when financial markets are highly liberalized and expectations are prone to recurrent cycles of optimism and pessimism."

While this should not blind one to the overwhelming merits of the system and absence of a plausible alternative, "the real task is to improve the system before suggested alternatives look more attractive than they really are."

But there is no single or simple answer to current economic problems. It is not so straightforward or easy, in practice, to distinguish policies directed to macroeconomic stability from those related to financial stability. Lack of stability in one area often contributes to instability in the other - as the experience of the industrial economies in the 1970s and 1980s, and more recently that of Japan, Mexico and South-East Asia show.

Hence for sustained improvement in living standards, policy initiatives need to be undertaken on a wide front. But different policies to support macroeconomic and financial stability share a number of underlying characteristics.

Transparency in conduct of monetary and fiscal policies is needed to provide an anchor for expectations. But transparency is also needed on part of participants in the financial system if market discipline is to contribute to prudent behaviour. And policies in both areas must avoid solving today's problems at the cost of making tomorrow's problems worse.

What happened in the financial markets, between August and October 1998, showed that probability distributions characterizing asset price movements may have fat tails - at least on the downside (meaning that frequency distributions should allow for a relatively high probability of large down-wide price movements).

Interactions between various forms of risk, previously assumed to be separable, led to massive price movements that threatened the health of financial institutions and even the functioning of markets themselves.

While most forecasters expect continued and indeed accelerating growth, there are many specific uncertainties which imply a wide margin of error, nor is it obvious that balance of current risks is symmetrical.

A generalized resurgence of inflation seems less likely than further disinflation or even deflation. Uncertainty in itself erodes confidence and leads to lower spending. Imbalances work in the same direction. When they are eventually resolved, those who gain may not adjust spending upwards, while those who lose have little alternative but to retrench.

And the imbalances in the world economy also imply some downside risks to the forecasts.

The overhang of productive capacity in traded goods worldwide is already putting downward pressure on prices in advanced industrial countries, even though export volumes from Asia have not yet fully responded to earlier depreciations.

In the US, protectionist pressures are on the rise even as the unemployment rate keeps falling from one low to another. And intensification of price competition makes firms vulnerable to any significant acceleration of costs. Should profits come under further pressure, the effect on equity prices could be significant and could in turn have an impact on consumption.

And the record trade imbalances, at some point, must imply a lower dollar and an appreciation of the yen and the euro. "Should this happen before the economies of Japan and continental Europe are growing healthily again, the downside potential for the global economy is obvious."

Conscious of these concerns, policy-makers have acted to sharply lower interest rates throughout the industrial world and in many emerging economies. While this was consistent with the desire to help calm market turbulence through a further injection of liquidity, monetary policy would work less effectively if prices actually fall in a generalized way, largely, but not solely because nominal interest rates cannot fall below zero.

But it would be a mistake to conclude that the answer to current global economic problems is simply to ease monetary policy further. Greater attention needs also to be paid to difficult issues concerning exchange rate regimes, fiscal policy and labour market reform.

In the area of financial stability, urgent action is required in many countries to restructure banking systems, and the corporate sector as well, and to ensure that once financial systems are made healthy, they stay that way for the foreseeable future.

In some important respects, the uncertainties and trade-offs faced by the US Federal Reserve are not normal. Inflation forecasts in the conduct of monetary policy for domestic price stability, is usually based on some notion of amount of excess capacity. But there is a great deal of uncertainty surrounding these in the US: estimates of capacity levels based on labour market data are completely different from those based on capital stock data. And, there exists to date "no conclusive evidence" for or against the US economy having entered a 'new era' of enhanced productivity growth.

Asset price movements have also imposed severe side conditions on the normal conduct of US monetary policy. The global financial turbulence last autumn contributed to the decision to lower interest rates, while the runup in equity prices along with the robust growth of credit might have suggested that higher interest rates were called for. A similar conclusion is suggested by the recent rebound in stock prices to record levels and the associated impact on consumer spending.

One great danger to the continued expansion of the global economy is that the US economy will overheat and fears of subsequent recession will undermine the stock market, reduce wealth and cut spending. And if the dollar were to fall simultaneously under the weight of capital outflows and a large trade deficit, a period of stagflation would not be an impossibility.

With global financial markets now calmer, the need to avoid such a combination of events should be an important consideration in formulating monetary policy in the period ahead.

In Europe, while the advent of the euro has been "executed masterfully," the challenge is how to conduct monetary policy in not just a new economic environment as one that by design is supposed to be changing rapidly under the impact of the euro itself.

Further complications arise from the fluctuations in the value of euro and both how to interpret them and respond to them. But with the European Central Bank's clear objective of price stability, "the dangers of undershooting now seem to be at least as great as those of overshooting"

In Japan, monetary policy is being conducted in a highly unusual environment - one of falling prices. While the outcome is not certain, the ingredients seem to be in place for a continuation of such deflationary pressures. The burden of real debt of corporations continue to rise, impeding investment. Unit labour costs are increasing and restructuring will add to unemployment - further depressing confidence and consumer spending.

"While purchases do not yet appear to have been deferred in expectation of further price decline, as is happening in China, the potential for this cannot be ruled out."

The Bank of Japan has responded by lowering interest rates to virtually zero, increasing liquidity in the banking system, and purchasing large quantities of private sector paper.

But to-date the effect has been essentially that of "pushing on a string" - raising the issue of what more, if anything, might be done.

The Japanese experience illustrates the limitations of monetary policy when nominal rates are already very low and excess capacity is very high, and provides some indication of both the benefits and limitations of making clear statements about objectives of public policy. But, "at the least, it should be clearly stated that the goal of ending Japanese recession and avoiding development of a deflationary psychology must, for the time being, take priority over concerns about trade account."

While the sharp fluctuations in the value of the yen and the introduction of the euro led to suggestions for better ways to cooperatively manage a tripolar global exchange rate system, no political agreements seem likely to alter significantly the current regime in which domestic monetary policy is directed primarily to domestic needs.

And an underlying problem is the continuing propensity of investors to borrow in low and lend in high interest rate centres, without considering the full potential for having to pay back in appreciated currency. "The destabilising aspects of market failures of this sort need further investigation."

In many emerging economies, new questions about exchange rates arose, and the principal lesson was countries should eschew variable peg regimes in favour of either something harder or voluntary adoption of managed floating. In terms of harder alternatives, Hong Kong and Argentina successfully defended their currency board regimes, but in both cases "uncomfortably high interest rates had to be accepted."

Others like Brazil did not choose to follow this path, but were forced to float the currency in an environment of crisis, with generally unsatisfactory outcomes. Brazil also chose let high interest rates make a contribution. To date, aided by a sharp improvement in primary surplus and unexpectedly good inflation performance, "the bet seems to have paid off."

But the challenge for Brazil and other countries with newly floating exchange rates is to find some other nominal anchor to guide domestic monetary policy over the longer term. This will not be easy, given the lack of an anti-inflationary history, poor data on credit and monetary aggregates and absence of reliable procedures to forecast inflation.

On fiscal policy, there has been little debate; but it is commonly asserted that fiscal stimulus in Japan has played a useful role, that fiscal consolidation is thought to be desirable in Europe and, that in the US fiscal position has greatly improved and no tightening seems required at this time.

"While these assertions have a large measure of validity, they all need to be qualified in the light of circumstances," comments BIS.

In Japan, the impact of fiscal stimulus packages have been diminished by rising consumer saving - reflecting growing uncertainty over job security, inadequate pension provisions and fear of rise in taxes in future to service accumulating debts.

In Europe, the benefits of medium-term consolidation cannot be questioned, but it should be remembered that one of the benefits of a strong fiscal position is the scope it affords for allowing automatic stabilizers to operate.

"One cannot rule out the possibility of a situation arising in Europe in which fiscal stimulus may again be an appropriate policy response."

In the US, textbook economics would suggest a tightening of fiscal policy would reduce domestic overheating and risk of a disorderly rise and subsequent sharp fall in the dollar. But this would make it all the more important, though politically unlikely, to encourage expansion of aggregate demand elsewhere.

And it is not clear that fiscal restraint is always useful when exchanges in emerging market economies come under pressure. In emerging markets, it is thought, that fiscal restraint may both strengthen exchange rates and bring down initially higher interest rates by reducing credit risk premium on foreign borrowing.

This argument seems logical in the case of Brazil, Russia and other countries with poor fiscal record.

"Whether it applies to countries in Asia and elsewhere whose fiscal history is sound seems less obvious." But recognizing how fickle markets can be in a crisis environment, it might still make sense in such cases to cut the deficit initially, but reverse the stance as soon as confidence is restored. "While the question of timing remains controversial, this is essentially what happened recently in the crisis-affected countries of Asia."

In view of the global conditions of excess capacity and high or rising unemployment in Europe, Japan and much of the emerging world, supply-side reforms are also urgently required. This may sound paradoxical, since such reforms will eventually further increase production potential. But changes in relative prices can also contribute materially to the resolution of economic disequilibria. Even with adequate restructuring of corporate and banking sectors current excess capacity in many industrial sectors mean that investments in these areas will weaken for years to come, with associated multiplier effects on jobs and income.

It is therefore essential that government restrictions and other profit-destroying impediments to investment in other sectors, particularly services, be removed. While this applies to emerging markets, many industrial countries too need to move in the direction of deregulation.

At the same time, to solve current problems, the overhang of excess industrial capacity in many countries and sectors have to be dealt with. Without an orderly reduction or take-up of excess capacity, rates of return on capital would continue to disappoint.

Closing down individual production plants in Asia is impeded by concerns about what traditional rivals might do. And given heavy sunk costs, it often makes sense to continue producing at a loss so long as variable costs are being covered. In this respect, low interest rates and continuing availability of finance through the banking system or from abroad can be important disincentives to restructuring. Declarations of bankruptcy and asset sales at low prices to generate profits for new owners may be another option. But this depends on adequacy of bankruptcy laws. Also concerns about social and political costs of laying off workers in the absence of an effective social safety net are further major obstacles to industrial rationalization throughout Asia. Another factor holding up corporate restructuring, not merely in Asia, but in many other parts of the world, is the suspect soundness of the banking system.

And while current problems in financial systems of emerging market countries were primarily generated domestically, international capital flows clearly exacerbated them. Even flows that are modest from the perspective of international capital markets can have highly disruptive effects on small economies.

"This suggests that such countries should dismantle controls on short-term inflows only very cautiously, particularly if there are doubts, and there normally will be, about the inherent stability of the domestic financial system. There should also be much less hesitation in using market-based prudential instruments, such as reserve requirements, to prevent banks from relying excessively on short-term borrowing in foreign currency. In association with a less tightly managed exchange rate regime, this could make a real difference.

Also, countries wishing to accommodate such capital inflows, for whatever reasons, should make greater efforts to prepare themselves for sudden outflows.

One way is to run trade surpluses, but such an approach would exemplify the fallacy of composition: "what kind of global imbalances will emerge, if all emerging market countries endeavour to do this?"

But part of the solution also lies in the functioning of international capital markets. Imprudent lending has been motivated by both shrinking returns on traditional businesses at home and the belief that various forms of safety nets would protect creditors. But recent losses suffered in Russia and China have made clear the potential for losses, and this seems to be having an effect on the behaviour of banks, even if purchasers of emerging market bonds have lost little of their enthusiasm. But this too will probably change - after recent suggestions that bondholders should normally share in any restructuring of a country's external debt.

However, the inference drawn from the rescue of the US Long-Term Capital Management Fund (that regulatory authorities and principal creditors considered a non-banking institution too complex to fail) might be worrisome for the message sent out to much bigger banks and dealing firms with their own large proprietary trading operations.

Advances in technology and deregulation have not only altered traditional banking behaviour, but also encouraged lending through securities markets, and the use of such markets by banks themselves, with implications for financial and economic stability.

The fact that liquidity may dry up as credit spreads widen, has the further implication that "in a market-driven system, the downswings may be more violent than upswings."

And with credit being provided by a multitude of investors in impersonal markets from which exit is easy, it is becoming increasingly difficult to organise concerted lending to sovereign borrowers in need of liquidity. "Akin to the attitudes of governments, banks ask why they should be bailing out others."

Through various channels, financial institutions including banks are becoming exposed to higher levels of market risk. And this is more highly correlated with credit than previously thought, since market exposures are built on leverage and credit risk is more highly correlated with liquidity risk than earlier realised. And it is now evident that risk models also offer a false sense of security - because they may lose their predictive powers in extreme market conditions, and their mechanical use may actually contribute to market turbulence.

In terms of public policy, it has become equally important to monitor markets closely and identify concentrations of risk.

In some countries where central banks have lost their responsibility for banking supervision, they have been given responsibility for overall financial stability. What this means in terms of support of markets needs to be better defined. "Whether central banks stripped of regulatory responsibilities will be able to obtain information they require when they need it, to use their emergency liquidity support powers wisely and effectively in a market-driven world remains a very open question. In continental Europe, the additional complication of a supranational central bank interacting with diverse national supervisors also need careful attention."

In an introduction, titled, "the darker side of the market processes", the BIS said of the events of last year that while financial markets in Asia had stabilised and the deep recession seen in many Asian economies had bottomed out, some potentially worrisome trends continued globally in both the real and financial sectors:

Divergences in economic growth both between and within country groups were remarkable. So too were trade imbalances. Real commodity prices hit 40-year lows and prices of many tradable goods fell as well. Credit growth in most industrial countries was surprisingly strong, though still weak in economies hampered by fragile banking systems. Equity prices continued to reach record high in many industrial countries and property prices began to move up. And the US dollar stayed generally firm, despite the increasing weight of external indebtedness, and the perception of the euro as a competing reserve currency. And due to past excesses and recent deregulations, financial restructuring continued apace.

Global disinflation under way for almost two decades quickened in 1998. But it would be unwise to extrapolate the experiences in industrial economies (of headline inflation falling to 1-1/2%), of unusual price stability in South-East Asia, exchange rate stability in China and Hong Kong SAR or domestic price falls in Latin America, and conclude that "global deflation is the principal policy concern."

There was an unusually high degree of divergence in economic performance between the advanced industrial and emerging economies, and significant differences among major industrial countries as well. Even within many industrial countries, the gaps between surveys for consumer confidence (high) and business confidence (low) were striking.

On various proposals for preventing future crisis, the BIS says that given how jealously nations guard their sovereignty, proposals for establishment of a global central bank, an international lender of last resort, a global super-regulator or an international bankruptcy court are unlikely to be acted on in the near future.

Given the scale of private capital flows, the private sector will inevitably have to become more fully and directly involved in crisis management and resolution. Many of the recommendations in this regard of the G-10 deputies, made after the Mexican crises, have been recently reiterated, "although they have not been acted upon to date."

Having suffered heavier losses in 1998 than at any time since the 1980s debt crisis, creditor have become much more aware of their risk exposure. But welcome as these might be in terms of reducing future excessive capital inflows into emerging markets, "they may have increased the tendency for private sector capital that is already there to be withdrawn pre-emptively."

The sharp drop in bank credits to Brazil in the third quarter of 1998 has indeed been interpreted by some as a pre-emptive move by banks fearing they would otherwise be forced into rolling over existing credits or providing new ones, within the context of the anticipated IMF-adjustment programme.

The Malaysian recourse to capital controls, as a response to the crisis, has given further impetus to the debate on whether full- scale capital account liberalisation is premature for most emerging market economies.

In particular, support has grown in recent years for measures to slow the inflow of short-term capital until markets, institutions and regulatory frameworks have been sufficiently strengthened. Measures to contain capital flows, when implemented through market-based instruments, such as reserve requirements that tax shorter-term inflows more heavily, can be useful, and if carefully devised, can avoid a domestic credit boom and asset price bubble, while maintaining a liberal attitude towards longer-term flows.

But there has been much less acceptance for imposition of controls on outflows, in particular where a liberal regime was already in place. While such controls may give authorities necessary room to formulate and implement adjustment programmes to restore investor confidence, controls could also be abused either to maintain an inappropriate policy far too long or delay restructuring a weak financial sector. The effectiveness of controls also decline as loop-holes are found and exploited, and the process set in motion to plug them become ever more complex.

As for monetary policy in industrial economies, with inflation approaching zero in some countries and prices even declining in others, issues regarding appropriate conduct of monetary policy in conditions of near price stability took on new importance in major industrial countries. An inflation rate close to zero suggests central banks may experience brief episodes of declining prices more frequently in the future.

A potential concern is that nominal wages may be rigid downwards, and this means that with price falls real wages may be raised, depressing employment and economic activity. A second concern is that nominal interest rates cannot be made negative, and if a contractionary demand shock occurs and prices start to fall, real interest rates will rise and could reduce aggregate demand further. (SUNS4450)

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

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