The Hindu Business Line : No simple fix to complex problems

The BIS' annual report for 2004-05 is unusually frank on the prospects of the world economy. Welcoming the reduction in inflation worldwide and an associated decline in its volatility, it voices concerns on other fronts. Warning that the current financial turbulence could herald another boom-bust phase, and uneasy at the diminishing value for corporate governance, the report also dwells on the US current account deficit and China's yuan problems. But it admits that the remedies are easier advocated than practised, says S. Venkitaramanan.

THE Bank of International Settlements (BIS) based as Basle, Switzerland, is the oldest international financial institution. It was established in 1930 to handle the reparations imposed on Germany after the First World War. It has gradually become the central bankers' central bank for exchange of ideas, imposition of standards, such as Basel Standards, and generally for ensuring financial stability. The annual meetings of BIS, to which the developing countries' central bankers were invited, used to be a treasured occasion where the central bankers would exchange views and advices. Of late, a few developing countries have been invited to full membership of BIS.

BIS' annual reports have been always eagerly looked forward to as a source of information analysis and advice. They have maintained a high standard of technical excellence and pragmatic slant. The BIS' latest annual report covering the year 2004-05 is no exception to the general trend of high quality of economic analyses and lucid presentations.

BIS is unusually frank on the prospects of the world economy. It admits that the going has so far been beyond "So far, so good", the heading of its introductory chapter. The report notes the welcome reduction in inflation worldwide and an associated decline in its volatility, notwithstanding the latest oil price hikes. A second trend has been a generally robust growth in the global economy, although accompanied by short-term volatility. The third feature noted by BIS is widening global imbalances, particularly the US' current account deficit. The BIS report also notes the growth of emerging market economies and their resilience in the face of economic stress.

BIS also notes that over a period, the global economy has been prone to financial turbulence of various sorts. The BIS report mentions, in particular, the Asian and Russian crises of the last decade which indicated the force with which financial shocks could be transmitted across financial markets and across countries. Another specific instance mentioned by BIS is the collapse of the LTCM (Long-Term Capital Management, a US-based hedge fund, whose failure had threatened to drag down US banks — which had lent to it — and the world financial system.

The BIS report mentions that in the recent period losses due to operational risks seem to have been on an upward trend, which has reflected not only increased complexity and IT dependence of modern financial systems, but also governance issues, such as those evidenced by the failure of Enron, Parmalat and AIG — the latest of such corporate misdemeanours in the US.

Another feature of the global financial system noted by BIS is the recurrence of credit, asset price and investment booms and bust. The BIS reports that it seems we are into a third phase of such a boom-bust cycle, starting from the economic boom of the 1980s. BIS warns of overheating in the housing sector, which is a significant feature as part of this cycle.

The BIS report warns, in general terms, that a boom will be followed by a bust, which has adverse consequences for general economic recovery. It is better to be forewarned than hug the fond belief that good times will last forever — a fitting warning in these times of the soaring Sensex and Nifty! Turning to persistent global economic problems, BIS is blunt in discussing the US current account deficit and its possible unravelling. Its latest dimension in terms of GDP is as high as 5.7 per cent, a danger signal. BIS notes that such levels are unprecedented for a country issuing a major reserve currency. This can lead to a disorderly decline in the US dollar, turmoil in other financial markets, a possible recession in the US and increased protectionism.

The BIS report urges everyone — it is obviously addressing central bankers and policy-makers — to consider unpleasant compromises now in order to avoid more unpleasant alternatives later. In its view, in order to rectify its current account imbalances, US needs to raise savings rates and cut budget deficits to curb imports and increase savings. Europe and Japan should on their part boost domestic demand by making their economies more flexible. BIS reiterates the IMF's advice that China for its part should allow its currency to fluctuate against the dollar so that it does not have such great export advantage. The bank is aware that such a suggestion may mean a great deal of practical problems for China with high unemployment and export losses as a consequence.

The BIS recognises that these remedies are more easily advocated than practised. It admits that its suggested cure implies that the US has to face the problem of unemployment if it raises interest rate. So too China has adjustment problems, if it revalues its currency and hurts its export sector. But the BIS report is optimistic about compromises being effected, given the current difficulties faced by the global economy.

It has to be admitted that the situation on the global front is complicated. The BIS report, while discussing various alternative suggestions, points out that it is not as if a return to the Bretton Woods system will enable an easy solution. It notes that in the current structure, the IMF lacks the power to make countries "adjust", especially if they are creditor countries, like China and Japan. It is not also as if IMF can straightaway ask President Bush to cut his budget deficit, which alone can help the country reduce its dependence on foreign capital inflows — credit from China, Japan, India and the rest of the world. In an attempt to clarify what might be probable solutions to the current imbroglio, the BIS toys with the idea of the establishment of a single international currency. This would, of course, imply that national authorities will have to relinquish domestic monetary control and move away from still existing capital controls.

A more realistic recommendation, says the report, might be to have a number of more formal currency blocks, based on the dollar, euro, yen and yuan. Clearly, they would have to float freely against each other. BIS notes that the proposal would have its limitations as speculative capital flows might still arise. It notes, however, that at a practical level, Asian economies seem to be establishing more formal contacts and procedures for regional monetary cooperation. However, they are still far from anything like exchange rate mechanism, which preceded the euro. This is the first time a responsible international financial institution, like BIS, recognises the tentative initiatives inspired by the Asian Development Bank's present President. Whether these initiatives will finally bloom into an AMU or AMF has been the subject of intense speculation. The BIS report, however, stops short of radical solutions to the current problems. It recommends that the most promising in the real world is a course of attempting "informal cooperative solutions, recognising inter-dependencies and the need to avoid circumstances that would lead to economic disruptions".

At the very least, this would require large creditor countries (say, China) to share views with debtors on an ongoing basis as to whether problems are emerging and if so what policies might help resolve them. National policy-makers would have to agree to constraints on their behaviour.

BIS warns that impediments to such action arising from perceptions of systemic risk, different cultures and analytical models and single national interest (turf wars) cannot be underestimated. A neat summing up of the state of the US-China debate, which is however conducted on a hegemon vs vassal framework! But BIS is right in its focus on solutions.

The road to solving the problem of the current international financial infrastructure is not smooth. BIS aptly sums up the situation in the pithy words: "Those who believe that there is a problem that needs fixing should not consider these impediments inseparable". Touche! BIS has, of course, the right to say what it does, given its long and rich experience in solving many monetary policy problems between countries. Hopefully, BIS will take special efforts to involve its considerable interlocutory skills in helping the international community to consider and reach a feasible pragmatic solution to the current imbalances and imbroglio. "So far, so good" is not good enough for an institution as powerful intellectually as BIS!

In conclusion, I may be pardoned for saying that BIS' latest annual report does not come out with any earthshaking suggestions in regard to the global economy. It is perhaps a reflection of the fact that the problems are themselves complex and there can be no simple "fix". The problems are, however, real — the developing world financing the developed world to run an excess of expenditure over its savings and to maintain a higher standard of life than is economically feasible.

This is capital flow in defiance of the laws of economic gravity, however much the search for return and safety drives the Asian central banks. There has to be a way out of this paradox of the poor billions of Asia funding the hegemon's greed for the good life and imperial power to boot!

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