The Hindu Business Line : Growing inflation worries BIS

The 77th annual report of the central banks' central bank cautions that inflation pressures globally seem to be increasing, while evidence of various imbalances continues to mount almost everywhere.

Being the central banks' central bank, the Bank for International Settlements (BIS) is usually heard with attention by governments that set store by "growth with stability". In its own characteristic way, couched in circumspect language, the Basle-headquartered global institution has warned that "inflation pressures globally seem to be increasing, while evidence of various imbalances continue to mount almost everywhere".

In its 77th annual report, released on Sunday at its headquarters in Switzerland, the BIS said in no unequivocal terms that "for those concerned about inflation pressures, economies with external deficits, particularly the large ones, should in principle bear a particular responsibility for contributing to the moderation of global demand growth."

Moderating growth

Noting that both short- and medium-term considerations should guide the path of fiscal policy in the same direction, the BIS said tighter fiscal policies could play a role in moderating global demand growth, though the dangers of fine-tuning in this regard are not negligible.

Taking a longer-term view, it said both government deficits and debts have been described as troublingly high in many countries and hence nations with twin deficits, fiscal and external, might reap particular benefits from further steps towards fiscal consolidation.

"This could serve to reduce risk premia, the likelihood of disruptive capital flight in the event of sharp movements in foreign exchange markets," the Bank said tersely.

The BIS hit the nail on the head when it contended that currently buoyant economic and financial conditions should provide support for structural reforms that would enhance growth worldwide.

Rightly, it observes that the greatest challenge for the real economy is to facilitate the shift into non-tradable services in countries that currently have large trade surpluses, in particular China and Japan. By the same token, a shift to tradables is needed in the United States to help reduce its current account deficit.

In a stoic assessment, the BIS report said: "We face a fundamentally uncertain world — one in which probabilities cannot be calculated — rather than simply a risky one." A first uncertainty has to do with the possible resurgence of global inflation and, potentially, inflation expectations.

Stating that estimates of capacity gaps in most of the major industrial countries show that they are approaching or have reached the limits of their potential, it said that given the still pivotal role of the US in the global economy, the possible inflationary impact of cyclically rising wages and declining productivity growth is a source of near-term uncertainty.

To near-term uncertainties about inflation and growth must be added a number of medium-term concerns, not least persistent and substantial global trade imbalances, it said asking whether this constitutes a problem, requiring a policy response to lower the possibility of large and perhaps abrupt movements in exchange rates.

Amplifying this point, it said that countries with large trade deficits are those where domestic demand has been growing relatively fast and where interest rates are relatively high as a result.

While, in principle, such countries should also have depreciating currencies, in practice, relatively high interest rates often induce private capital inflows of such a magnitude as to cause the exchange rate to appreciate rather than depreciate and to raise domestic asset prices, which leads to more spending rather than less. It warned that both these developments would cause the trade deficit to worsen further.

A final set of medium-term uncertainties has to do with great potential vulnerabilities in financial markets and possible knock-on effects on financial institutions. The prices of virtually all assets have been trending upwards, almost without interruption, since the middle of 2003.

"There seems to be a natural tendency in markets for past success to lead to more risk-taking, more leverage, more funding, higher prices, more collateral and in turn more risk-taking," it said adding that the obvious question is who might be hurt if there is a market mayhem.

The BIS said one area of concern is market risk and leverage and the fact that banks are now increasingly providing bridge equity, along with bridge loans, to underpin the still growing number of corporate mergers and acquisitions, is a not "a good sign". A closely related concern is the possibility that banks have either intentionally or inadvertently retained a significant degree of credit risk on their books.

The BIS further said that assuming that the big banks have managed to distribute more widely the risks inherent in the loans they have made, the question is who now holds these risks and can they manage them adequately?

It cautions that much of the risk is embodied in various forms of asset-based securities of smaller banks, pension funds, insurance companies, hedge funds, other funds and even individuals, who have been prodded to invest by the generally high ratings given to these instruments.

Structural Changes

Given the complexities of the financial markets worldwide, the BIS said that in emerging market economies the essential point is that liberalisation needs to be preceded by structural changes that will allow financial systems to remain resilient in the face of both domestic and external shocks.

Even as domestic policymakers have faced the challenge of responding to external shocks, it becomes all the more crucial now "in our globalised and market-driven world".

Hence, interactions among nations remain the bedrock and real response to face challenges. Lamenting a tendency for national authorities to go it alone and for global dialogue to go no further than that, the BIS report pertinently and pointedly concludes that this is yet another "global imbalance that urgently needs to be dealt with".

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