The Hindu Business Line : A fire drill for the global economy

The Bank of International Settlements has in its latest assessment sounded a note of caution in regard to risks posed by global imbalances, an important factor in which is the US' current account deficit. Emphasising fiscal prudence and inflation-fighting, its observations on the global stress-test should be of vital interest to India, as to other developing countries. The BIS recognises that inflation management in the US and other developed economies owes as much to globalisation as to monetary successes.

The Bank of International Settlements (BIS), the central bank of central banks, is known for being judicious, prudent and, at the same time, conservative in the management of the world economy. Its annual reports are looked forward to as sources of information, insightful analysis and prudent advice by bankers and other policy-makers.

While the BIS has been conservative in its latest assessment of the risks and prospects for the global economy, it has at the same time sounded a note of warning and caution in regard to risks posed by global imbalances.

The BIS annual report for 2005-06 clearly identifies as important amongst the global imbalances, the current account deficit in the US, which is running currently around 6 per cent of its GDP and shows no sign of getting reduced.

The unwinding of the current account deficit — which incidentally increases the US' liabilities — will inevitably lead to a devaluation of the dollar.

In spite of the conventional economic wisdom suggesting such an outcome, the dollar has recently appreciated, incidentally increasing the woes of the US' exporters.

The BIS report points out that the rectification of the current account imbalance in the US may need a steep depreciation of the currency.

Depreciation of the order of 5-6 per cent would itself involve a large-scale structural transformation of the US economy moving substantial shift of workforce from the non-traded sector to the traded sector.

Whether such a depreciation, if at all feasible, will by itself enable the US rectify its current account deficit is, of course, a billion-dollar question!

Causes for US current account deficit

While the BIS report identifies various causes for the US' current account deficit, it points out, that the US has earned more from its investments abroad than it has been paying the investors in its own securities. The net investment income — which is the balance between its outgoes on its liabilities and earnings on its assets — has been positive for the last few years.

The rest of the world is, therefore, being taken for a ride. It has invested its funds in the industries and equities of the US, which bring the other countries lower returns than they themselves allow the foreign investors in their own countries. The suggested explanation offered for this gap being favourable to the US is that when the US' investors invest in developing countries, it brings in a good deal of high technology and management skills.

The BIS report recognises that the devaluation of the order suggested for US dollar would involve substantial erosion of the value of investments by both private and official investors, who today hold billions of dollars in US dollar-denominated securities.

(Incidentally, India's reserves of $160 billion, most of which is in the greenback, are also at risk). This will similarly erode the Chinese investments. Given US devaluation, China will face the difficult task of generating adequate exports.

It might also lead to a large number of bankruptcies, both in the US and in emerging markets. These forecasts are not made lightly.

Stress-testing

The BIS recognises that there is need for stress-testing the financial institutions of different countries, especially emerging economies, to analyse the likely effects of the consequences of such a transformation.

It even contemplates the creation of a Special Purpose Vehicle, an off-shelf bank, which can handle the financial assets of banks that may have lent to companies and business-houses at risk.

While the details of the suggestions regarding stress-testing are, no doubt, important, it is significant that the BIS considers it important to warn the global economic community that there is a crisis waiting to happen and that the world economy should get ready to face it.

The BIS report explores various options in the event that such a shock occurs. Whether it will come as a big bang or as a whimper is not clear. The preferred solution may well be to inject adequate liquidity and offer a regime of low interest rates. But this solution offers the risks of a moral hazard. It will encourage further risky behaviour by economic agents. The BIS has clearly worked out a range of prospective solutions to the impending crisis, if and when the imbalances are settled, as they have to be.

The question whether the crisis can be averted now is academic. The denouement is already part of the design of the structure of global economic growth, which has taken place in the last two decades in the US, Europe and in emerging economies.

That the US has ridden a boom and a bust cycle on the basis of accommodative monetary policy is undeniable. Whether the culmination of a bang or a bust will unravel the present crisis is a matter that vitally concerns the US as well as the rest of the world. The BIS poses this question and seeks to answer it.

The BIS has a readymade agency which can undertake further examination and implementation of its suggestion. This is the "Global Forum for Growth and Financial Stability", which has initiated stress tests in connection with certain central banks.

India can use BIS inputs

It is only appropriate that India should consider the various issues raised in the BIS annual report and prepare its own policy framework to deal with the crisis that is forecast to happen.

The economic statesmen of the world have to decide whether the solution should be on the Keynesian line or otherwise. The time is appropriate for the central bankers and the Finance Ministers of the world, who assemble from time to time, to consider convening a Brettonwoods-style conference to discuss the issues raised by the BIS report most pertinently and in a timely manner.

I hope they will have the wisdom and opportunity to make a significant contribution to the resolution of the problem the BIS has identified in common with many other experts, who have considered the state of the world.

In referring to the low inflation environment, which has characterised the global economy, particularly the developed world, in the last two years, the BIS report emphasises the special contribution of globalisation, in the form of supplies of cheaper goods from the manufacturing facilities located in countries like China.

The BIS report also emphasises, however, that there may be a limit to this contribution as the capacity of the Chinese manufacturing sector, which today offers goods at low prices, may be restricted by the high prices of inputs, such as crude oil, iron ore, etc. It is also possible that the wage levels in China are rising.

The BIS recognises that inflation management in the US and other developed economies owes as much to globalisation as to monetary successes. But the BIS hints that there are other areas in China, and other countries too, which are candidates for China's place in the manufacturing cycle.

Therefore, globalisation, which was once dreaded, particularly in the US, and led to protectionist campaigns, has become a friend of the US consumer and has helped the legendary Federal Reserve in its fight against inflation.

The BIS report is rich in its analysis, especially on the global economic imbalances. But it offers little advice of specific relevance to emerging economies, except that it emphasises fiscal prudence and inflation-fighting, which are slogans favoured by central bankers.

Of course, its general observations on the global stress-test should be of vital interest to India, as to other developing countries.

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