What is the Bank for International Settlements?

The Bank for International Settlements or BIS is an international organization that fosters international monetary and financial cooperation. It is the central bankers’ bank. Cooperation between banks is facilitated through the BIS. This cooperation is most visible at times of crisis, although it certainly is not limited to only those times. Established on May 17, 1930, BIS is the world's oldest international financial organization. It provides a forum to promote discussion and policy analysis among central banks and within the international financial community; a center for economic and monetary research; a prime counterparty for central banks in their financial transactions; and an agent or trustee in connection with international financial operations. The head office is in Basel, Switzerland with two representative offices in Hong Kong and in Mexico City. Crisis management was apparent in the immediate aftermath of the terrorist attack on September 11, 2001 as central banks sought to assure global liquidity in the financial markets. And crisis management has been apparent during the past year as banks worldwide work to stem the credit crisis. Each year at this time, the BIS issues an annual report. This year’s report — the organization’s 78^th — deals with the current financial crisis. Below is a brief summary of that report.

The current crisis according to BIS

According to BIS, the current turmoil in the world’s main financial centers is “without precedent in the postwar period.” The risk of a U.S. recession combined with sharply rising inflation in many countries have increased fears that the global economy might be at a tipping point. The reason for these precarious economic conditions is emanating from the “powerful interaction between financial market innovation, lax internal and external governance and easy global monetary conditions over many years.” The report continues “rather than seeking to apportion blame, however, thoughtful reactions must be the first priority.” The report emphasizes that in the future it will be very important to consider all facets and their interactions and not just dwell on recent financial market innovations that are currently receiving so much attention. If the focus is too narrow, remedial policies of limited scope could be chosen and they in turn, could prove inadequate to manage a crisis with deep roots both in the real economy and in the financial sector. It is unquestionably important to identify “what is different” but we must also recognize “what is the same”.

BIS identifies the primary reason of today’s problems as excessive and imprudent credit growth over a long period. According to the organization, this threatens two unwelcome outcomes, but it was unclear which would emerge first. One outcome is higher inflation as the world economy gradually approaches its near-term production potential, while the second is an accumulation of debt-related imbalances in the financial and real economy which could eventually become unsustainable and lead to a significant economic slowdown. Now the global economy seems to be experiencing both simultaneously, albeit with different countries having significantly different exposure to these common threats and thereby presenting policymakers with a complex situation. It should be noted that these threats differ in their immediacy — inflation is actually rising, while significantly slower growth remains only a possibility in many parts of the world. With inflation a clear and present threat, and with real policy rates in most countries very low by historical standards, a global bias towards monetary tightening would seem appropriate. However, circumstances — actual and prospective — vary between countries, therefore ruling out a "one size fits all" response. Moreover, should the global economy slow sharply and inflationary pressures recede, the bias to tightening would evidently also be reduced.

In the current and prospective environment, the effectiveness of lowering policy interest rates might be significantly reduced in the aftermath of a credit-induced spending boom. In view of the potential negative side effects of such a policy ― that is the risk of encouraging further financial imbalances and misallocations of real resources ― complementary policies might be envisaged to avoid overburdening monetary easing. Expansionary fiscal policy could be used for example, but in many countries current debt levels leave little room to maneuver. Steps to recognize and deal with losses and debt overhang problems in a timely and orderly way must be a high priority.

No one would argue that there always have been financial crises with significant economic costs or that they will ever be eliminated. However, BIS thinks that steps could be taken in advance both to mitigate the excesses in the expansionary phase of the credit cycle and to further reduce the costs in the downturn through better crisis management.  

The roots of the present turmoil are both similar and different from earlier episodes. A number of study groups have already identified “what is different” in financial markets today and have made many sensible suggestions for changes that would reduce the dangers these factors apparently pose. At the same time, these suggestions also seek to maintain wherever possible the benefits these new developments offer. However, what has received less attention are potential cures for “what is the same” — namely the inherent procyclicality of the financial system and excessive credit growth. This lack of attention is surprising for two reasons. First, recognizing excessive credit growth as the underlying problem helps explain not only the current financial turbulence, but imbalances in the real economy and rising inflation as well. Second, it could be that the tendency for rapid credit expansion to have dangerous side effects is actually growing. The trends towards globalization and consolidation, as well as securitization, increase not only the likelihood of excessive behavior in the upturn but the costs of downturns as well.

In the aftermath of a long credit-driven boom, it is not surprising to see financial market turmoil, which in turn, slows real growth and temporarily increases the rate of inflation. The crucial questions now have to do with the severity of these individual trends as they now appear and how they might interact. Their interaction at this time appears to point to a deeper and more protracted global downturn than the consensus view seems to expect. At the same time, inflationary forces, particularly in emerging market economies, could also prove unexpectedly strong and persistent. A major factor in inflation prospects everywhere is likely to be the behavior of wages, but in some countries the effect of a depreciating exchange rate on domestic prices could also play an unwelcome role.

Perhaps the principal conclusion to be drawn from today's policy challenges according to the BIS is that it would have been better to avoid the build-up of credit excesses in the first place. Going forward, this could be done through the establishment of a new macrofinancial stability framework, which would call for both monetary and macro-prudential policies to "lean against the wind" of the credit cycle. Recognizing that cycles can be attenuated but not eliminated, a number of preparatory steps are also suggested that would allow periods of financial turmoil or crisis to be more effectively managed.

Recommendations

BIS said what seems to be needed is a “new macrofinancial stability framework to resist actively the inherent procyclicality of the financial system. By using macro-prudential regulatory instruments as well as monetary tightening to lean against the upturn, the worst excesses could be avoided.” As an example they note how central bank focus on inflation is said to have affected the inflationary expectations process. “And fewer excesses on the way up would probably imply less damage to clean up afterwards, as well as more room to ease policy since this would have been tightened more systematically beforehand.”

The first salient feature would primarily focus on systemic issues while a second feature would be a more symmetrical or countercyclical use of policy instruments. In the first case, monetary policy might be tightened even with projected inflation under control, given a sufficiently worrisome combination of rapid credit growth, rising asset prices and distorted spending or production patterns. In the second case, policy instruments would be tightened in the expansionary phase of the credit cycle and eased in the downturn. A third feature would be still closer cooperation between the central banking and regulatory communities in trying to identify the build-up of systemic risks and in deciding what to do to mitigate them.

BIS points out that there “are many practical impediments to making a macrofinancial framework operational. The first is that not everyone accepts the hypothesis that excessive credit growth is the root of the problem. Nor is everyone agreed that it might prove difficult to clean up the mess after such periods of excess. While hopefully it will not come to that, if the costs of the current turmoil continue to mount and policy measures prove largely ineffective, such beliefs are more likely to be re-evaluated. A second problem is the practical one of recognizing when resistance to the upswing becomes necessary. And a third problem is mustering the will to act, to take away the punch bowl at the party when the time is right. These problems are real but they should not be insurmountable, and they pale against the difficulties likely to be encountered when an unresisted boom turns to bust.

“Finally, it cannot be denied that a still more traditional factor was also at work. Real interest rates globally — not just in a few advanced industrial economies — have been at unusually low levels for much of this decade. With inflation initially low and stable, policy rates, long-term rates and risk spreads failed to increase commensurately as global growth rose to record levels. The expansion of monetary and credit aggregates surged, while foreign exchange reserves rose by unprecedented amounts as emerging market economies intervened massively to keep their exchange rates from appreciating. Moreover, as with low interest rates, the global trend towards faster monetary and credit growth was seen in almost every major region of the world.

“One plausible explanation for this extended period of easy monetary and credit conditions is that central banks have not yet fully adjusted their domestic policies to reflect increasingly important global influences. For many years, global inflation was maintained at low levels, aided by the tailwinds of numerous positive and overlapping supply shocks arising from deregulation and technical progress, but perhaps due even more to the entry of major emerging economies into the global trading system. Similarly, there are dangers in saying that food and energy prices can be ignored in setting domestic policy because they are externally driven. For the world as a whole, these are not external supply shocks, but rather seem to have been primarily demand-driven. These examples indicate that our domestic frameworks for policymaking need to be better adapted to the realities of globalization.

“Given the variety of the influences underlying current economic and financial difficulties, their interactions and their long-standing nature, we should not expect a quick and spontaneous return to normalcy. Nor should we expect quick and easy policy solutions. “

Economic concerns

Monetary policy across geographic regions reflects many influences and is consistent with diverging opinions about just how severe the current turmoil might become for individual national economies. There is also little certainty with respect to inflationary prospects other than suggesting that it is more likely to rise further than to suddenly fall. As a result, some analysts see parallels today with the early 1970s when inflationary pressures rose sharply, while others with the early 1990s, when banking systems and the economy were weakened by an overhang of private sector debt. “In the end, both might well prove right.” Globalization increases the possibility of contagion across geographical regions.

BIS is concerned about rising global inflation. The organization notes that commodity prices have been at the heart of inflationary acceleration in part because neither supply nor demand reacts quickly to price changes. They also note that wage increases have remained quiescent. However, higher prices have cut consumer wages almost everywhere and this in turn has prompted many governments to resort to administrative measures to tamp down price increases. While a global economic slowdown would help reduce inflationary pressures, given the inertia in the inflation process, it still might imply a long period of high inflation along with slower growth, i.e. stagflation.

Growth and inflation prospects will also be affected by exchange rate movements, given the U.S. current account deficit and rising external debt levels. BIS noted that so far the dollar’s decline has been “remarkably” orderly. But future exchange rate changes could have significant costs as well as benefits. “Countries like the United States, whose currencies are depreciating, should see growth benefit from trade substitution effects. The United States will further benefit from valuation effects, since most of its debts are denominated in dollars while its assets are measured in appreciating foreign currencies. Conversely, those with appreciating currencies are likely to see growth suffer on both counts.”

Bottom Line — one size does not fit all

Given the conflicting risks within individual countries, each national central bank must carefully assess several issues of varying importance to each country. BIS lists four. The first is the strength of existing inflationary pressures and the risk of inflation expectations ratcheting upwards. The second is the likelihood of other potential shocks to inflation going forward. For example, commodity prices, exchange rates and terms of trade would loom large here. Third is an evaluation of the extent to which potentially large changes in asset prices and perceptions of wealth might affect the outlook, particularly against a backdrop of elevated debt levels. And finally, they must make a related judgment on the health of the financial system and the likelihood of a credit crunch emerging.

Obviously, interest rates would differ across countries given decisions about the considerations above. Rising inflation is a clear danger everywhere but it is already a reality in most emerging market economies where food counts for a greater percentage of consumption than in developed countries. And the track record of price stability in some regions is less well established while the threats to growth from balance sheet excesses and a tightening of credit standards seem generally less in evidence than in some key advanced industrial countries. If monetary policy were to be tightened relatively more in the emerging market economies, this would also imply a greater willingness to allow their exchange rates to rise in consequence. The latter is to be recommended, both as an inflation-fighting tool and as an instrument for reducing global trade imbalances. Since, within the advanced industrial economies, similar considerations seem to warrant a tighter set of policies in continental Europe (relative to the United States, where the threat of recession seems greater), higher emerging market exchange rates would also help alleviate upward pressure on the euro.

Should governments feel it necessary to take direct actions to alleviate debt burdens, it is crucial that they understand one thing beforehand. If asset prices are unrealistically high, they must eventually fall. If saving rates are unrealistically low, they must rise. And if debts cannot be serviced, they must be written off. Trying to deny this through the use of gimmicks and palliatives will only make things worse in the end.

Source — Bank for International Settlements. Annual Report. June 30, 2008.