G. Srinivasan

New Delhi, June 28

The three major policy challenges confronting the world economy today include ‘a convincing start to reducing budget deficits in the advanced economies, fostering the necessary balance sheet adjustments in the financial industry and building a broader financial stability framework', says the Bank for International Settlements (BIS).

Releasing its 80th Annual Report at its annual general meeting (AGM) in Basle (Switzerland) on Monday, the BIS General Manager, Mr Jaime Caruana, said the “room for manoeuvre for macroeconomic policies has narrowed.”

He warned the Western countries that “without substantial fiscal reforms, bouts of volatility in financial markets could well become more intense and interact strongly with the fragilities in the financial system,”, thereby disrupting markets, tightening funding conditions and sharply increasing risk aversion.

Taking the ongoing onslaught against “front-loaded policies to cut budget deficits” in major European countries head-on, Mr Caruana contends that it is easy for critics to state the adverse effects of such policies on income growth and employment in the short-term. But in the current unsettled times, he said, the alternative of having to cope with the financial and macroeconomic disruption that a sudden loss in market confidence could cause would be “far worse”.

Fiscal consolidation

Contrary to the assertions of G20 leaders of going overboard with fiscal correction bid, the BIS said “a programme of fiscal consolidation — cutting deficits by several percentage points of GDP over a number of years — would offer significant benefits of low and stable long-term interest rates, a less fragile financial system and ultimately better prospects for investment and long-term growth”.

In its 102-page annual report surveying the global financial sector, the BIS, known as the central bankers' central bank, said emerging market economies (EMEs) were recovering robustly albeit increasing inflation pressure. It said the decline in global economic activity began to slow in the second quarter of 2009 and gave way to growth towards the middle of year. The size of both the contraction and the expansion varied greatly across countries. China, India and Poland avoided a contraction altogether, it said adding that output growth merely slowed and then soon returned to pre-crisis level.

However, expansionary policies at home, combined with the impact of loose monetary and fiscal policies in the large advanced EMEs, have led to signs of overheating. Core inflation has increased sharply in India, while growth in the resource-intensive industrial sectors of EMEs, especially China and India, has pushed up commodity prices, it said.

“With continuing low interest rates in advanced economies, tighter monetary policy in the EMEs would encourage capital flows in the short-run. But resisting the exchange rate appreciation pressure associated with these inflows would lead to faster credit growth and increase the risk of asset price overshooting,” it cautioned.

Even as the country's apex bank RBI is due to review its monetary policy next month, the BIS has succinctly stated “there may be no effective alternative to raising interest rates, allowing greater flexibility in exchange rates and reducing reliance on foreign exchange intervention.” It asked EMEs and advanced economies to work in concert on strengthening global monetary arrangements to ensure that in any subsequent crisis, a sufficient supply of international currency is available; for the foreseeable future, it said, that currency remains the US dollar.

Commenting on the financial sector, it said for several decades, financial institutions have resorted to high leverage as a way to boost short-term profitability, at the cost of marked volatility in their performance. “Weak capital, illiquid assets and reliance on short-term funding created vulnerabilities that led in recent years to large losses and systemic distress”, it bemoaned. Hence, the priority of policymakers now is to incorporate in the regulatory framework the stronger standards being imposed by the market place, it said adding that higher-quality capital, lower leverage and more stable funding should buttress the sector's future resilience.

Finally, it said regulators must establish a macro prudential framework to promote the stability of the financial system as a whole, while fiscal authorities must work to maintain long-term sustainability, ensuring that their policies absorb rather than amplify shocks by building reserves in good times that will be available for response in the bad times. Central banks the world over must confront booms in asset prices and credit as being the threat to stable prices and growth that they are, it added.

geeyes@the hindu.co.in

(This article was published in the Business Line print edition dated June 29, 2010)
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