Info Service on Finance and Development (Jul19/02)
Geneva, 2 Jul (Chakravarthi Raghavan*) – Monetary policy can no longer be the main engine of economic growth, and other policy drivers need to kick in to ensure the global economy achieves sustainable momentum, says the Bank for International Settlements (BIS) in its Annual Economic Report.
The Economic report along with the annual report 2018/19 of the Basel-based Bank for International Settlements, the central bank for the world’s central banks, was released Sunday, 30 June.
The BIS’s financial results show a balance sheet total of SDR 291.1 billion (USD 403.7 billion) at end-March 2019 and a net profit of SDR 461.1 million (USD 639.5 million).
In its flagship economic report, the BIS calls for a better balance between monetary policy, structural reforms, fiscal policy and macro-prudential measures, that would allow the global economy to move away from the debt-fuelled growth model that risks turbulence ahead.
“Navigating the way to clearer skies means balancing speed with stability and conserving some fuel to cope with possible headwinds,” said BIS General Manager Agustin Carstens, at the annual meeting of BIS shareholders at Basel on 30 June.
“A sustainable flight path requires the long-overdue full engagement of all four engines of policy, rather than short-term turbo charges,” he added.
In the Economic Report, the BIS says that although global expansion hit a soft patch last year, the resilience of service industries and strong labour markets can support growth in the near term. Employment increases and solid wage rises have sustained consumption.
Still, significant risks remain, including trade tensions and rising debt, particularly in the corporate sector in some economies.
“As well as clouding future demand and investment prospects, the trade tensions raise questions about the viability of existing supply chain structures and about the very future of the global trading system,” said Carstens. “Trade wars have no winners,” he pointed out.
Other risks to the outlook, according to the BIS, include weak bank profits in several advanced economies and deleveraging in some major emerging market economies (EMEs), particularly China. Necessary moves there to curb credit growth act as a drag on activity.
EMEs’ greater sensitivity to global financial conditions and resulting capital flows has meant that, since the financial crisis, they have had to cope with strong spillovers from accommodative monetary policy in advanced economies.
EME monetary policy frameworks have sought to tackle the trade-offs by combining inflation targeting with currency intervention, complemented with macro-prudential measures to address the build-up of financial vulnerabilities.
“This kind of multiple-tool policymaking is not yet very well anchored conceptually. EME monetary policy practice has moved ahead of theory. Theory has to catch up,” says Claudio Borio, Head of the Monetary and Economic Department of BIS.
BIS notes that in 2017, unusually and so late in the upswing, there was a synchronised global expansion at rates above estimates of potential.
Some deceleration was on the cards. But when it came, in the second half of 2018, it appeared much stronger than expected, causing tremors in financial markets and anxiety about a possible impending recession.
Faced with the prospect of a weaker economy and an abrupt tightening of financial conditions, the major central banks put the very gradual monetary policy tightening on pause. (As a result), the recession has not materialised.
Looking at the components of global output, BIS notes that in the second half of 2018 world trade came to a halt, manufacturing decelerated and investment lost pace. By comparison, services and consumption held up relatively well, propping up the expansion.
However, says BIS, going beyond such an “accounting exercise”, it is much harder to identify the underlying forces at work, though it is possible to point to a number of cross-currents and multiple forces that exerted downward pressure on growth.
First, and quite prominently, political factors left their imprint on the economy and weighed on the minds of economic decision-makers. Besides some country-specific political factors, trade tensions loomed large, andÂ related uncertainty and concerns inhibited activity, especially investment.
Second, China slowed as the authorities sought to bring about the much needed deleveraging of the economy to make growth more sustainable. And given China’s heft and tight interconnections in the global economy, the slowdown quickly spread around the world, with global value chains acting as a powerful transmission channel.
Third, financial conditions tightened somewhat in parts of the world as US monetary policy continued to normalise until late 2018 and the US dollar strengthened.
While holding up remarkably well by past standards, emerging market economies (EMEs) came under some pressure, given the heavy reliance of their firms on dollar financing.
Finally, in several advanced small open economies and a number of EMEs, financial cycles appeared to shift from expansion to contraction, weighing down on expenditures.
The slowdown would have been sharper without resilience elsewhere that served to buffer the weakness from manufacturing and trade. The continued strength of labour markets, accompanied by a modest pickup in wage growth was a supporting factor. Employment expanded further, pushing unemployment rates to multi-decade lows in several economies.
Another factor, at work in some of the large economies at the heart of the Great Financial Crisis (GFC), was the financial cycle upswings, most notably in the United States. In those cases, the post-crisis household deleveraging provided room for the corporate sector to re-leverage, to the point of creating some vulnerabilities.
By late May (when the report was being written) financial markets became jittery again, especially owing to an intensification of trade tensions.
Nevertheless, consensus forecasts, while noting downside risks, continue to see a global economy in a soft patch. The forces supporting the expansion are expected to prevail.
Looking at the deeper forces influencing business fluctuations and evaluating possible risks to the outlook for the global economy beyond the next few quarters, BIS notes the forces at work, providing the backdrop for recent developments.
The first is the inflation process, pivotal in determining the monetary policy stance. Inflation has remained very subdued despite many economies operating close to, or above, standard estimates of economic potential and with record low unemployment. In the long held view of BIS, globalisation and technological advances are responsible, and additionally, demographics-induced changes in the labour force may have led to underestimates of economic slack.
With labour struggling to regain the bargaining power lost over the past decades, wages have finally been responding more clearly to tighter labour markets, with firms showing little sign of reacquiring pricing power. Even as wages have been rising faster than productivity in many countries, prices have not kept up.
Also, ever since inflation has been low and stable, starting some three decades ago, the nature of business fluctuations has changed.
Until then, it was sharply rising inflation, and the subsequent monetary policy tightening, that ushered in downturns. Since then, financial expansions and contractions have played a more prominent role.
The second force at work has been finance and its role in the economy. The GFC was just the most spectacular instance of this role. This justifies the greater attention policymakers now pay to financial markets, credit developments and real estate prices.
Moreover, in a financially highly integrated world, capital flows across borders hold sway. And smaller economies are generally at the receiving end; hence, the high sensitivity of EMEs to global financial conditions.
The third force is lack of productivity growth. Growth accelerations of the type experienced in 2017 could lead to sustained growth only at a new, higher pace if a level shift in productivity growth takes place. However, productivity growth has been on a marked downward trend in advanced economies as a group for a long time.
And the slowdown became more marked following the GFC. The impaired financial system is likely to have played a role in impeding the allocation of resources to their best use.
It is surely no coincidence, says BIS, that trade has lagged behind output and that investment has been correspondingly weak.
Whatever the actual reasons, lower productivity growth is constraining sustainable expansions, at least in the advanced economies, where the frontier for the rest of the world is set.
The fourth force, of more recent vintage, is the political and social backlash against the open international economic order that has grabbed all the news headlines recently. The trade and political tensions in the period under review are just the most glaring manifestation.
Not all of the recent slowdown can be ascribed to trade conflicts and protectionism. The slowdown in trade and productivity predates the retreat into protectionism in the last two years.
However, the sound and the fury of trade conflict and the associated uncertainty have imparted a downward twist to the slowdown. Nor should the longer-term challenges be taken lightly.
From a historical perspective, it is not unusual to see such surges of sentiment in the wake of major economic shockwaves: the Great Depression marked the end of the previous globalisation era. It is too early to tell how this surge will evolve; but it will clearly be a force to contend with in the years to come.
Of these forces, says BIS, political factors, in particular those related to trade policies, will continue to cast a long if unpredictable shadow over the world economy. In addition, the factors underlying productivity growth are slow moving, providing the backdrop to business fluctuations.
Perhaps the forces that can be explored in more depth are finance and the inflation process, says BIS, in assessing possible financial vulnerabilities and how they might play out under different conditions.
Despite the long journey since the GFC, its imprint is still discernible. In many of the countries less affected by the GFC, financial expansions have reached an inflexion point. As a group, these economies account for around one third of global GDP.
Private sector credit growth has slowed relative to GDP and, in a number of cases, property prices have started to fall. After the strong credit expansion, these countries are now saddled with historically high household debt levels, and some with high corporate debt as well.
A specific feature of EMEs has been the rapid growth of FX debt, mostly in the corporate sector – although it has not quite reached previous peaks in relation to GDP. Size-wise, the only systemic economy in this group is China, where the authorities are engaged in the delicate balance of deleveraging the economy without slowing down growth, adapting policy as circumstances, including the trade tensions, evolve.
If past experience is anything to go by, the contraction phase of the financial cycles in this group of countries is likely to continue, acting as a drag on growth.
Countries that were at the heart of the GFC, such as the United States and a number of European economies, have tended to see marked differences at the sectoral level. Household debt in relation to incomes has declined after a long phase of balance sheet repair and is on a stronger footing. By contrast, the corporate sector in some countries has shown clear signs of overheating.
The overall financial expansion will remain a source of strength for the economy for now.
Perhaps the most visible symptom of potential overheating is the remarkable growth of the leveraged loan market, which has reached some $3 trillion.
While firms in the United States -and, to a lesser extent, the United Kingdom – have accounted for the bulk of the issuance, holdings are spread out more widely.
The condition of the banking sector is, in some respects, paradoxical. Country differences aside, it is much better capitalised thanks to the post-crisis regulatory reforms.
However, asset growth among the major banks has slowed sharply since the GFC. Bank equity growth has been similarly lacklustre. The slow growth of bank equity reflects, in part, chronically low profitability of banks, particularly in many euro area countries.
Some of the reasons for low profitability can be traced to legacies from the GFC and the macroeconomic environment, most notably the persistently and unusually low nominal interest rates. Others reflect more structural factors, especially excess capacity in a number of key banking systems. Looking ahead, a looming competitive threat to banks comes in the form of the big techs.
Overall, the global economy has been unable to jettison its debt-dependent growth model. Indeed, aggregate debt (public plus private) in relation to GDP is much higher than pre-crisis. At the same time, interest rates – nominal and real – remain historically low.
And financial conditions in advanced economies, notably in the largest among them, remain accommodative from a longer-term perspective. As a result, should the global economy slow down at some point, it is hard not to imagine that the debt burden would increase further.
Against this backdrop, the evolution of inflation plays a key role. Should inflation start to rise significantly at some point, it would induce central banks to tighten more.
This could cause tensions in financial markets and put heavily indebted borrowers – private and public – under pressure. Should inflation remain subdued and below central banks’ objectives, despite their forceful attempts to push it up, current economic conditions could continue. But this would also extend risk-taking, increasing vulnerabilities.
Policymakers can successfully negotiate this terrain. But as the pause in the monetary policy normalisation process indicates, the narrow path described in last year’s report has proved to be a winding one.
Flowing from this diagnosis, BIS says that for clearer skies to appear, the policy mix needs to be re-balanced.
Higher sustainable growth can only be achieved by reducing the reliance on debt and reinvigorating productive strength. This would relieve some of the burden monetary policy has been bearing since the GFC and avoid the expectation that this policy can be the engine for sustainable growth. Its more appropriate role is that of a backstop, given that its main focus is delivering price stability while supporting financial stability.
Since the GFC, monetary policy has found itself in a complex position. After fighting the fires of the crisis, it took over successfully much of the burden of supporting the recovery.
But given the persistence of economic weakness and an inflation rate stubbornly below objectives, interest rates have been kept unusually low for unusually long, and central bank balance sheets have ballooned. As a result, the room for policy manoeuvre has narrowed considerably.
Moreover, the very low rates have contributed, in part, to some of the financial vulnerabilities seen now. This points to the possibility of some delicate inter-temporal trade-offs. Depending on circumstances, it is possible that actions that yield clear benefits in the near term may risk generating costs in the longer term.
One such example is the relationship between low interest rates and short-term economic activity, on the one hand, and risk-taking and debt accumulation over the longer run, on the other.
Another is the high sensitivity of financial markets to policy tightening once they have grown dependent on prolonged monetary policy accommodation. In turn, both of these factors can potentially reduce the future room for manoeuvre and complicate normalisation.
Fully aware of these delicate and complex tradeoffs, central banks and other authorities have implemented policies to reduce the possibility of adverse future outcomes. Notably, they have adopted far-reaching financial sector reforms. So far, adverse outcomes have been avoided, but this does not give licence for complacency, including with regard to monetary policy.
EME central banks, BIS points out, have been contending for some time with a complex environment. The evolution of monetary policy frameworks in the EMEs, is the result of the high sensitivity of these economies to global financial conditions: the waves of capital flows and exchange rate pressures can put a strain on these countries’ balance sheets.
As a result, monetary policy practice in EMEs has moved ahead of theory. Rather than strictly sticking to inflation targeting with freely floating exchange rates, the vast majority have combined it to varying degrees with foreign exchange intervention.
And all of them have complemented it with the active use of macro-prudential measures. That way, they have gained a measure of freedom to better reconcile price and financial stability over the medium term. At a more structural level, the key challenge is to develop domestic financial systems so as to reduce the sensitivity to global financial conditions in the first place.
The experience of EMEs showcases one way to achieve a more balanced policy mix: a strong prudential framework, with respect to both micro- and macro-prudential dimensions, dealing with individual institutions and the financial system as a whole, respectively.
With primary reference to the micro-prudential dimension, now that most of the post-crisis financial reforms are in place, the key challenge, BIS says, is their full, timely and consistent implementation.
In the process, BIS adds, regulators and supervisors should resist unwarranted pressures to backslide and weaken standards. As the memories of the GFC fade, those pressures will intensify.
[Though BIS says that post-GFC, most financial reforms are in place, in the United States, the prime source of the GFC, the reforms of the Dodd-Frank Act required the formulation of 398 new rules for the financial sector. Three years after Dodd-Frank became law, only 155 of these rules had been finalized. And given the effort of the administration of President Donald Trump to undo everything that was achieved under his predecessor, President Obama, it seems extremely unlikely that the remaining new rules for the financial sector, mandated by the Dodd-Frank Act, will see the light of day. And even rules already instituted will be unlikely to be implemented or enforced.]
Appropriate fiscal policies can also help achieve a more balanced policy mix, BIS suggests.
In countries where sustainability is in danger, the objective should be to bring public finances under control, to avoid fiscal dominance and limit risks to the financial system. But where fiscal space is available, it should be used judiciously to boost sustainable growth and, if the need arises, to support aggregate demand.
Suitable measures include, in particular, making the tax system and expenditures more growth-friendly, not least through well chosen infrastructural investments where productive opportunities exist. Reducing the bias of the tax system in favour of debt is an obvious example. In doing all this, it is important to avoid the trap of carrying out pro-cyclical policies.
One reason why public sector debt-to-GDP ratios have been increasing at the global level is precisely the asymmetrical use of fiscal policy, increasing deficits during contractions but failing to consolidate during expansions. Hence, the reduced room for policy manoeuvre compared with pre-crisis.
But the most important set of policies is structural. Hard as it is politically, it is essential to revive the flagging efforts to implement policies designed to boost growth. The analysis of the regulatory response to inroads in finance by big techs offers rich material to examine more closely and concretely some of the challenges involved.
The objective is to ensure that one can reap the potentially large benefits that such technological innovations can bring about while managing the potential risks. This requires tackling delicate issues that range from financial stability to competition and data privacy.
At the core of this triangle is the treatment of data, which the digital revolution has brought to the fore. Ensuring a level playing field that promotes competition under an adequate regulatory umbrella is key.
Whatever the precise answer, it will require more than ever the close cooperation of different authorities, both nationally and internationally, said BIS.
The BIS report, as well as some of the remarks of the BIS General Manager and his top aides at the annual meeting seemed to suggest that Central Banks themselves could introduce digital currencies; and/or under the same regulatory conditions that apply to banks, allow big tech and their currencies and financial systems access to facilities of the central bank to bring about financial inclusion.
BIS adds: “The skies are not clear yet. The path is narrow and winding. But the means to negotiate it exist. They should be deployed.”
[* Chakravarthi Raghavan, Editor-Emeritus of the SUNS, contributed this analysis of the BIS report.]