The Hindu Business Line : BIS Platinum Jubilee report: `Build on financial stability'

Central banks the world over have to shed the business-as-usual approach and consolidate the gains made so far in their quest for maintaining international financial stability through the cooperative efforts of all stakeholders. This is the loud and clear message of the Platinum Jubilee Report of the Bank for International Settlements, says G. Srinivasan.

IT IS incredible that the central bankers' central bank, the Bank for International Settlements (BIS), is celebrating its platinum jubilee this year, completing 75 years in the pursuit of greater monetary and financial stability and cooperation. India's Reserve Bank of India, is one among the 55 central banks that are members of the BIS.

This Basle-based financial institution held its annual general body meeting (AGM) on June 27; and its well-crafted annual report, released on the occasion, documents the pitfalls and prospects of the global financial system.

At the outset, the report poses two questions centring on policy issues. What policies might best help preserve the many satisfactory features of today's economic and financial world? And, over the long haul, is there need for a new macro-financial stabilisation framework to prevent the build-up of both domestic and international imbalances?

A retrospective glance at the BIS' long history of fostering cooperation among central banks reveals four prominent features over the last two decades. The foremost is a reduction in the level of inflation worldwide and an associated decline in its volatility.

The second is generally robust growth in the global economy, again accompanied by lower short-term volatility, with sluggish growth in Japan and Germany ( exceptions to the rule).

The third feature is the widening of external imbalances and the fourth is the phenomenon of credit, asset price and investment booms, often followed by financial difficulties of various kinds.

The report hails three structural shifts in the global economy. First, the liberalisation of many emerging markets has unleashed competitive forces that have led to major changes in the industrial world. The integration of China and other erstwhile socialist countries into the global market economy is an unprecedented occurrence.

Second, there has been a pattern of liberalisation in financial markets, which has made them efficient and given them global reach. Third, monetary authorities worldwide have focussed increasingly on bringing down inflation and keeping prices stable thereafter. The report adds that learning to live with low inflation, a liberalised financial sector and recent advances in financial technology takes time.

During the learning process, mistakes have been made but their incidence and costs would decline. Even as the global economy performed well in the fiscal year ending March 2005, the BIS detects some "worrisome signs", reminiscent of the inflationary pressures that built up in the late 1960s. But, fortunately, closer scrutiny shows enough differences from that earlier period, to conclude that history is unlikely to repeat itself.

Yet, these differences indicate future problems and internal and external imbalances that could unwind with a potentially disruptive impact, cautions the BIS. Among the internal imbalances, real policy rates in many industrial countries, including Asian economies, continue to hover around zero. Nominal rates on long bonds, as well as credit spreads and measures of market volatility are low. The household saving rate in many industrial countries has been trending sharply downwards and debt levels are at record highs. House prices in many countries have never been higher. And in China, the investment ratio has risen to a startling 50 per cent of GDP.

External imbalances have never been larger in the post-War period. The widening current account deficit of the US is a serious long-term problem. It could eventually lead to a decline of the dollar, associated turmoil in other financial markets and even recession. It could also lead to a resurgence of protectionist pressure.

"The unprecedented size of the deficit, the speed with which external debts are growing, the increasing reliance on the official sector for deficit financing, and the fact that the US' borrowing has primarily financed consumption (rather than investment), all suggest an eventual problem," the BIS report says.

It contends that the surplus countries of continental Europe and Asia face deeper conflicts as they consider the use of macroeconomic instruments to encourage domestic demand. In both regions, concerns remain about fostering inflationary pressures stemming from higher commodity prices. While Europe used up its fiscal room for manoeuvre some years ago, in Asia, the fiscal positions seem healthier.

Yet in many of these countries, including China, concerns about the ultimate costs to the taxpayer of restructuring the financial system are a restraint that cannot be ignored.

Dealing with exchange rate changes, the report says the obvious candidate for revaluation would be the Chinese renminbi and other Asian currencies that take their cue from it. While Beijing has legitimate reasons for concern about the revaluation — the health of the financial system and the income stream of the Chinese farmers — these concerns would be better dealt with through domestic policies.

Greater flexibility in exchange rates would help curb the massive capital inflows that threaten the sustainability of China's long-term expansion. It would also give scope for monetary policy to resist domestic inflation.

The report does not shy away from admitting that policy solutions for each country, considered in isolation, often stand in mutual contradiction. Hence, it avers that financial imbalances, both domestic and international, need more systematic attention that might be accomplished through an evolutionary adaptation of the current policy framework. In consonance with its remit of highlighting factors influencing risks in the banking sector, it states that the resilience of the banking sector depends on the types of risks to which it is exposed.

First, exposures arising from the rapid growth in credit to households; second, the risks from exposure to currency mismatches; third, exposure to long-term government debt and, last, exposure emanating from changes in banking structure amid increasing competition.

Stronger competition could put pressure on profitability which might reduce the franchise value of the banking sector and encourage a switch to riskier non-traditional business lines.

Stating that the pickup in economic activity in emerging economies during recent years has been associated with much higher lending to households, the BIS report says this is due to the perception that credit to households offers banks a profitable and comparatively safe opportunity to diversify, away from lending to corporations. However, this could also lead to problems.

A second risk to which banking systems might be exposed is the currency mismatches in the economy as a whole. In some countries (particularly in Asia) this reflects in large central bank foreign reserves; indeed, private sector foreign currency mismatches remain significant in a number of countries. The financial sector must take care to manage these risks.

A third area of concern is that the banking sector's exposure to government which has tended to rise in all emerging market regions. In some cases, this shows up as an increase in bank holdings of public debt, and reflects the recapitalisation of banks in the aftermath of crises.

In other cases, as the BIS report cites, Indian banks have traditionally been major holders of government bonds. They might, as a result, face associated market risk: higher long-term interest rates could spawn capital losses, and such risks are not always hedged in emerging market economies.

Considering that the Indian banking system today suffers from all the above identified factors it is time that the powers-that-be in the North Block picked up the gauntlet and started cleaning up the system to make it deliver cost-effective results for the various segments of the economy.

The message from this year's BIS report is loud and clear: Central banks the world over have to shed the business-as-usual approach and consolidate the gains scored so far in maintaining international financial stability through the cooperative efforts of all stakeholders.

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