The Hindu Business Line : BIS annual report on global economy — Inflation and other underlying imbalances

The global economy today confronts not only the normal uncertainties associated with inflationary pressures, but also various financial imbalances. Hence, price stability should be pursued more flexibly and, in conducting monetary policy more weight should be given to indicators of rising imbalances, says the BIS annual report. G. SRINIVASAN surveys the report. The report prescribes fiscal policy tightening in both industrial countries and emerging markets.

With a medley of factors poised to truly re-shape the near-term future of the world, the central bankers' central bank, the Bank for International Settlements (BIS) on Monday released in Basle (Switzerland) a conspectus of the global economy, warts and all, through its annual report. The occasion was the annual general meeting of BIS, which is mandated to ease payment settlements and ensure orderly conduct of monetary policy and banking transactions for the stability of the financial system world-wide.

Financial imbalances

In BIS' view, the world economy today confronts not only the normal uncertainties associated with responding to incipient inflationary pressures, but also various financial imbalances — internal and external.

These imbalances are the by-product of a decade or more of robust increases in global supplies, lagging domestic demand in large economies other than the US, and an over-reliance on easy monetary policies to reduce output gaps.

It said increased supplies were due to the re-entry into the global framework of previously closed economies, supported by improved communications and technology everywhere. To this must be added the ongoing increase in productivity growth in the US, in particular.

Continuing deregulation of markets for both goods and factor inputs in the industrial countries is another reason for the positive supply shocks over the last decade or so.

Always on the look out for price pressures that might feed inflation, the BIS is not off the mark when it points out that many issues, lying just beneath the surface, warrant attention. First, the data may not reliably measure the underlying inflation trends, already made difficult to quantify by the massive shifts in relative prices in recent years.

For instance, it said that in most countries the costs of housing services have been rising sharply, but these tend to be either badly measured or even ignored while calculating the consumer price indices. Second, the concept of `core' inflation is based on the exclusion of volatile price components, but the price of excluded energy has been trending upwards for over three years now. It is the reality of consumers facing higher costs for energy and housing services that could still pass through to wage settlements.

Third, in many countries, the effects of higher energy prices have been muted by regulatory constraints and fiscal subsidies, but these will have to be removed over time. And, finally, as the global economy moves closer to full capacity, the inflationary pressures are likely to rise.

Increased productivity

The BIS report also noted that production processes in the global economy have become significantly more integrated, particularly since the early 1990s. This implied higher levels of global productivity and massive increases in the effective supply of labour.

Together, these factors have continued to put direct downward pressure on the prices of traded goods and services. But there have also been continuing indirect effects, with attendant implications for wage and price-setting behaviour.

"Not only has foreign labour become increasingly available to deal with bottleneck problems, but the threats to move whole factories to lower-cost jurisdictions have become increasingly credible," the report said.

Last year, merger and acquisition (M&A) activity further contributed to these longer-term trends, particularly in Europe. Moreover, "what became distinctly more noticeable last year were the efforts of enterprises from emerging market countries to seek control over companies in other emerging markets, as well as industrial countries. This marks a significant and politically more sensitive phase in the globalisation process."

Current account imbalances

According to BIS, global savings grew in 2005 to 22 per cent of GDP. This is about 1.5 percentage points higher than the cyclical trough in 2002 and comparable to the average for the 1990s. Higher savings in the emerging economies continued to drive the recent increases.

Oil exporting emerging economies accounted for a growing share of global savings in 2005; their saving rates rose four percentage points. Saving patterns in emerging Asia diverged. China's national saving rate grew further and is now at about 51 per cent. In contrast, savings rates in the rest of emerging Asia declined. Global current account imbalances continued to widen last year. The external payment deficit of the US reached $800 billion in 2005 or 6.5 per cent of GDP, up $140 billion within one year.

While the Euro area logged broadly neutral external payments, the current account positions of individual member-countries widened sharply: Germany's surplus rose to more than $110 billion (4 per cent of GDP) even as Spain's deficit widened to almost $85 billion (7.5 per cent of GDP). The Japanese surplus remained large, at about $170 billion or 3.5 per cent of GDP.

Energy prices to blame

Higher energy prices were again a key factor for widening external imbalances in 2005. The oil trade balance of advanced oil-importing countries deteriorated 1.5 per cent of their GDP. In the case of the US, net energy imports rose $70 billion last year, almost the same amount as the total increase in merchandise exports; energy now accounts for one-third of the US trade deficit.

The BIS report draws attention to the discomforting fact that the basic sustainability condition — that, in the long run, the stock of government debt should not grow faster than nominal GDP — has not been met in the US and the Euro area since 2001 and in Japan since the late 1980s.

"The persistence of large budget deficits even in an environment of strong global growth and low interest rates has raised concerns about the long-term sustainability of public finances in the major industrial countries. These concerns are aggravated by looming budgetary pressures due to expenditures required to sustain an ageing population and the associated prospect of lower potential growth," the report said. The report said that most emerging market economies still have significant fiscal deficits, with the median being 1.6 per cent in 2005 and they find it difficult to reduce expenditure. One problem is the fixed claims on budgetary resources, including interest payments on debt, high government wage or pension bills or generous social-security benefits. These are the challenges confronting Brazil and Turkey and countries such as China and India.

In oil-exporting countries, increases in revenue associated with rapid economic growth or oil price windfalls have created pressures to increase wages or social spending. Besides hampering expenditure reduction, this restricts the scope for needed spending to improve the quality of civil service or support priority sectors such as health, education and infrastructure. The report prescribes fiscal policy tightening in both the industrial countries and the emerging markets. Fiscal restraint is especially important for the US and countries facing both high government and current account deficits.

"A credible, medium-term package of fiscal restraint in deficit countries would also reassure foreign creditors that their longer-term interests are being protected. Indirectly, it would also be a welcome source of support for an orderly adjustment of the US dollar," the report observed.

Approach to price stability

As imbalances threaten the global financial system, the BIS stated candidly that the current conventional approach to price stability may need refinement. Hence, it argued that price stability should be pursued more flexibly by using a longer forecast horizon than is currently fashionable and that more weight should be given to indicators of rising imbalances in conducting monetary policy.

As a member of the BIS, the Reserve Bank of India (RBI) should focus more on the emerging imbalances in the domestic economy such as current account and fiscal deficits that threaten to bulge in the face of rising expenditure and narrowing avenues for revenue-raising by the coalition government at the helm.

More Stories on : Economy | RBI & Other Central Banks

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Providing social security to unorganised workers

A steely catalyst

BIS annual report on global economy — Inflation and other underlying imbalances

Pricing the poor man's fuel

Time for re-assessment of crop bio-technology

Corporate bond market — Needed, an efficient trading platform

Flaws in PDS

Taxing zones