Report From The BIS

http://www.bis.org/speeches/sp130623.pdf

Use the link for graphs and charts.


Making the most of borrowed time
Jaime Caruana, General Manager of the BIS
on the occasion of the Bank’s Annual General Meeting
in Basel on 23 June 2013
2013 BIS AGM, General Manager’s speech 1
Good afternoon, ladies and gentlemen.
Since the beginning of the financial crisis almost six years ago, central banks and fiscal
authorities have supported the global economy with unprecedented measures. Policy rates
have been kept near zero in the largest advanced economies. Central bank balance sheets have
doubled from $10 trillion to more than $20 trillion. And fiscal authorities almost everywhere
have been piling up debt, which has risen by $23 trillion since 2007. In emerging market
economies, public debt has grown more slowly than GDP; but in advanced economies, it has
grown much faster, so that it now exceeds one year’s GDP. These trends can be seen in
Graph 1.
Monetary policy stance and public debt Graph 1
Monetary policy stance
Per cent USD trn
General government debt in the G20 countries
% of GDP USD trn
1 Advanced economies: Australia, Canada, Denmark, the euro area, Japan, New Zealand, Norway, Sweden, Switzerland, the United Kingdom
and the United States; emerging market economies: Argentina, Brazil, Chile, China, Chinese Taipei, Colombia, the Czech Republic, Hong
Kong SAR, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, the Philippines, Poland, Russia, Saudi Arabia, Singapore, South Africa,
Thailand and Turkey. 2 Weighted average based on 2005 GDP and PPP exchange rates. 3 Sum across the economies listed.
Sources: IMF, International Financial Statistics and World Economic Outlook; OECD, Economic Outlook; Bloomberg; Datastream; Global
Financial Data; national data.
Without these forceful and determined policy responses, the global financial system could
easily have collapsed, bringing the world economy down with it. But the subsequent global
recovery has remained halting, fragile and uneven. In the United States, the expansion
continues, albeit at a moderate pace. In major emerging market economies, growth is losing
momentum. Most of Europe has fallen back into recession. At the same time, the general
downward trend in productivity growth has not been receiving enough attention from
policymakers.
As the risks mounted around mid-2012, central banks rode to the rescue yet again. The
ECB addressed market fears with the promise that it would do “whatever it takes” within its
mandate to save the euro. It followed up with a conditional programme to buy sovereign debt
of troubled euro area countries. The Federal Reserve, the Bank of England and the Bank of
Japan likewise pushed forward with additional expansionary measures.
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Policy rates (lhs):1, 2 Central bank total assets (rhs):1, 3
Advanced economies
Emerging market economies
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As a percentage of GDP (lhs): In USD trillions (rhs):
Advanced economies
Emerging market economies
2013 BIS AGM, General Manager’s speech 2
And while large advanced economies were expanding their unconventional policies, central
banks in many emerging market economies lowered their target policy rates, in some cases
reducing them to their 2009 levels.
As global financing conditions eased further, private credit continued to grow at a rapid
pace in some countries, lending standards weakened, equity prices reached record highs
worldwide, long-term yields hit record lows and credit spreads compressed. Even highly
leveraged firms could borrow at long-term rates far below the rates they had to pay before the
crisis.
But easy financial conditions can do only so much to revitalise long-term growth when
balance sheets are impaired and resources are misallocated on a large scale. In many advanced
economies, household debt remains very high, as does non-financial corporate debt. With
households and firms focused on reducing their debt, a low price for new credit is not terribly
relevant for spending. Indeed, many large corporations are using cheap bond funding to
lengthen the duration of their liabilities instead of investing in new production capacity. It does
not matter how attractive the authorities make it to lend and borrow – households and firms
focused on balance sheet repair will not add to their debt, nor should they.
And, most of all, more stimulus cannot revive productivity growth or remove the
impediments that block a worker from shifting into a promising sector. Debt-financed growth
masked the downward trend in labour productivity and the large-scale distortion of resource
allocation in many economies. Adding more debt will not strengthen the financial sector nor
will it reallocate resources needed to return economies to the real growth that authorities and
the public both want and expect.
Central banks have borrowed the time that the private and public sectors need for
adjustment, but they cannot substitute for it. Moreover, such borrowing has costs. As the
stimulus is sustained, it magnifies the challenges of normalising monetary policy; it increases
financial stability risks; and it worsens the misallocation of capital.
Finally, prolonging the period of very low interest rates further exposes open economies to
spillovers that are now widely recognised. The challenges are particularly severe for the
emerging market economies and smaller advanced economies where credit and property
prices have been rapidly growing. The risks from such a domestic credit boom at a late stage of
the economic cycle are hard enough to manage. Strong capital inflows exacerbate such risks
and challenges for market participants and authorities; and they expose economies to large
sudden reversals if markets expect an exit from unconventional policies, as volatility during the
past few weeks seems to indicate.
In short, the balance of costs and benefits entailed by continued monetary easing has been
deteriorating. Borrowed time should be used to restore the foundations of solid long-term
growth. This includes ending the dependence on debt; improving economic flexibility to
strengthen productivity growth; completing regulatory reform; and recognising the limits of
what central banks can and should do.
Ending the dependence on debt
Extending monetary stimulus is taking the pressure off those who need to act. Ultra-low
interest rates encourage the build-up of even more debt. In fact, despite some household
2013 BIS AGM, General Manager’s speech 3
deleveraging in some countries, total debt, private and public, has generally increased as a
share of GDP since 2007. For the advanced and emerging market economies shown in Graph 2,
it has risen by about 20 percentage points of GDP, or by $33 trillion – and rising government
debt has been the main driver. This is clearly not sustainable.
Low rates have allowed the public sector to postpone consolidation at the risk of a further
deterioration in sovereign credit quality and damage to longer-term growth. There is plenty of
evidence that as public debt surpasses about 80% of GDP, it becomes a drag on growth –
because it raises debt servicing costs (and uncertainty about the future tax burden); it increases
sovereign risk premia; and it reduces the room available for countercyclical policy.
Change in debt, 2007–12
In percentage points of GDP Graph 2
Sources: IMF, World Economic Outlook; OECD; BIS; national data.
Government attempts at fiscal consolidation need to be more ambitious. Average headline
deficits in the major advanced economies have narrowed by about 3½ percentage points. This
is broadly in line with previous episodes of fiscal adjustment, but it is not sufficient to bring
public debt back to a sustainable path. In many cases, government debt is rising further,
notwithstanding record low servicing costs. Very low long-term interest rates are making
government spending look cheap. But the belief that governments do not face a solvency
constraint is a dangerous illusion. Bond investors can and do punish governments hard and
fast when they believe that fiscal trajectories have become unsustainable.
The need for fiscal adjustment is especially large for governments that currently enjoy the
lowest funding costs. Our calculations show that, when taking into account rising spending for
health care and pensions, some countries – for example, the United Kingdom or the United
States – would have to improve their primary fiscal balance by more than 10 percentage points
in order to reduce public debt to 60% by 2040. These are huge adjustments. And the numbers
for many other advanced economies are not much smaller.
When growth is strong, reducing deficits and debt relative to GDP is less painful – some
believe even painless. And the adoption of plans for future consolidation could reap immediate
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Turkey
Government Non-financial corporations Households
2013 BIS AGM, General Manager’s speech 4
benefits by boosting confidence. Hence, some ask: Why not announce consolidation plans now
but act later, when times are better?
The answer is that, without strong action now to tackle the root of the problem, credibility
will be low and the repeated growth disappointments of the past few years are likely to
continue. It is very difficult to credibly tie the hands of future governments. Instead,
consolidation is postponed indefinitely, or at least until bond investors decree otherwise. And
then the pain will be large indeed, and the consolidation will tend to be very unfriendly to
growth.
Rather than debating when to consolidate, we should be discussing how. Policymakers
should be carefully choosing the composition of adjustment that will minimise the short-term
costs of fiscal consolidation and maximise the boost to potential output. Successful
consolidations tend to focus on cuts, especially in government consumption and transfers,
rather than on tax increases. Proposals to raise revenues should consider taxes that are less
distortionary than those on labour and capital.
Strengthening productivity growth
Debt-financed growth has made it easier for authorities to delay the contentious work of
removing labour and product market rigidities. The boom masked the need to reform
economies even as resource allocation became less and less efficient. And the crisis-motivated
macroeconomic stimulus of the past few years has exacerbated these distortions. Hence,
progress in labour and product market reforms has been slow.
Productivity growth and sectoral imbalances Graph 3
Labour productivity growth1
Per cent
Change in GDP growth vs sectoral imbalances2
Coeff = –1.2, t = –3.2 Percentage points
CA = Canada; DE = Germany; FR = France; GB = United Kingdom; IT = Italy; JP = Japan; US = United States.
1 Average annual real GDP per hour worked. 2 The scatter plot represents a number of advanced and emerging market economies, but
does not include Greece, which had a change in GDP growth of –11% and a sectoral imbalance index of 0.3. With Greece included in the
sample, the regression coefficient becomes –0.8, t = –1.4. 3 Defined as average absolute changes in the sectoral employment share
between the beginning and end of the Great Recession, ie from 2007 to 2009. 4 Average annual growth rate between 2010 and 2012
minus average annual growth rate between 2001 and 2007.
Sources: European Commission; IMF, World Economic Outlook; OECD; BIS calculations.
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CA DE FR GB IT JP US
1980–90 1990–2000 2000–08 2008–12
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Sectoral imbalances3
Change in real GDP growth rate4
2013 BIS AGM, General Manager’s speech 5
Strong and sustainable growth requires speeding up reforms that enhance economic
flexibility. As Graph 3 shows, labour productivity growth has been declining in major advanced
economies. And the accumulation of large sectoral imbalances – especially the outsized
property and financial sectors – has also held back growth. The imbalances have also hindered
the creation of new jobs – imposing huge costs on many individuals and the economy as a
whole. These developments call for measures that enhance economic flexibility, allowing labour
to be employed where it is most productive and allowing ideas to generate new products and
markets.
Pushing through reforms and changing behaviour are always difficult because the costs are
paid upfront while the benefits accrue only over long periods. But reforms now also face
economic and financial headwinds, while near-zero interest rates and forceful central bank
action reduce the urgency to act.
Difficult as they may be, however, the reforms are critical to attaining and preserving
confidence. And they are critical to limiting the human suffering and economic damage
imposed by long-term unemployment. Notably, progress in these areas has been most visible
in the countries where market pressure has been the most severe, but much remains to be
done.
Completing financial sector reform
A healthy financial system is the backbone of a vibrant economy. Growth, innovation and
job creation require sound financing. Banks are making uneven progress in rebuilding their
balance sheets. Progress is visible in the evolution of bank capital and in spreads on credit
default swaps (CDS). But more is needed by banks in some countries to recognise bad assets
and make funding more stable, thus regaining investors’ confidence.
The CDS spreads in the left-hand panel of Graph 4 suggest that more needs to be done in
the euro area in particular. Banks there have made progress in strengthening their capital
buffers, but uncertainties remain, not least about the link between the health of banks and
sovereigns. Breaking this link requires continued consolidation of public finances and,
importantly, further determined steps to complete a full European banking union, including not
only a single rulebook and single supervisory mechanism, but also a single resolution
mechanism and common deposit insurance.
The foundations for a much healthier system have been put in place, in a process that
started with the implementation of the Basel III capital and liquidity standards, continues with
the work on resolution regimes, and is proceeding with reforms of over-the-counter derivatives
markets and shadow banking.
Restoring confidence in the resilience of financial markets and institutions will require
transparent and consistent implementation of the new rules. But consistency does not mean
uniformity – diversity is necessary if we are going to have dynamic and stable markets. The
issue is how to best counteract banks’ incentives to maximise reported regulatory capital.
An effective regulatory framework must be risk-sensitive and provide market participants
with comparable and reliable information about banks’ risk-taking. But the framework must
also be robust to the inherent uncertainties in risk measurement. Does that mean that a simple
ratio for gauging risk can provide the answer? Probably not. Even the simplest ratio or rule
2013 BIS AGM, General Manager’s speech 6
becomes complex when expressed in regulations. However, a combination of risk-sensitive
balance sheet measures and a simpler leverage ratio can make for a framework that is more
robust to the complexity and uncertainties that are inherent to any risk assessment in a
complex financial system.
More generally, mechanisms within and across borders that can resolve any failing financial
institution without public funds will further boost confidence in the financial system. Those
mechanisms are essential to remove the implicit public subsidies and moral hazard that come
with being too big to fail.
Bank CDS spreads and capital Graph 4
Bank CDS spreads1
Basis points
Core Tier 1 ratio
Mean and range, end of year4
1 Five-year on-the-run CDS spreads in US dollars; simple average across selected banks. 2 Belgium, France, Germany, Greece, Ireland,
Italy, the Netherlands, Portugal and Spain. 3 Brazil, China and Singapore. 4 Means are simple averages across selected banks. 5 Banco
Bilbao Vizcaya Argentaria, Banco Santander, BNP Paribas, Commerzbank, Deutsche Bank, Société Générale, UniCredit. 6 Barclays, HSBC,
Lloyds TSB Group, Standard Chartered. 7 Bank of America, Bank of New York Mellon, Citigroup, JPMorgan Chase and Wells Fargo.
Sources: Bankscope; Markit; BIS calculations.
Recognising the limits of what central banks can and should do
Three trends stand out as central banks moved to provide further stimulus over the past year:
 First, they stepped up interventions in government bond markets. The Federal Reserve
and the Bank of England now hold sizeable shares of the outstanding stock of their
respective government issues. Including the bonds acquired by foreign central banks in
their currency interventions, central banks hold about one third of all US Treasuries
outstanding.
 Second, central banks targeted specific parts of the monetary transmission mechanism
for repair. They used tools that included specific lending programmes, such as the Bank
of England’s Funding for Lending Scheme; purchases of government bonds of specific
countries, such as the ECB’s Securities Markets Programme; the Federal Reserve’s
continued purchases of mortgage-backed securities; and the Bank of Japan’s
subsidising of lending, entitled Measures to Support Strengthening the Foundations for
Economic Growth.
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United States Euro area2 Japan EMEs3
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2013 BIS AGM, General Manager’s speech 7
 Third, central banks made forward commitments. Most were conditional, such as the
Federal Reserve’s pledge to continue its balance sheet expansion at least until
unemployment reaches a certain threshold and the ECB’s assurance that, through its
Outright Monetary Transactions programme, it will buy government bonds of countries
that fulfil certain conditions.
Half a decade ago, most, if not all, of these measures were unthinkable. Their emergence
shows how much responsibility and burden central banks have taken on.
But this overdependence on central banks poses significant challenges for the economy as
a whole. Progress with repairs and reforms would make it easier for central banks to normalise
monetary policy.
A rise in long-term interest rates from the abnormally low levels shown in the left-hand
panel of Graph 5 will of course have an economic and financial impact. How severe it will be
crucially depends on the dynamics of the rate increase process. Experience suggests that the
upward trajectory of long-term rates could be abrupt and volatile – and the complexity of the
global financial system makes it impossible to predict what the adjustment will look like.
Emerging market economies could be particularly exposed to a spike in market volatility
and a reversal of the recent strong capital inflows that are evident in the right-hand panel of
Graph 5. The recent volatility in emerging market interest rates, equity markets and exchange
rates confirms this view.
Nobody knows exactly how central banks will exit, or what they will exit into. In any event,
they will need to employ great skill in both implementation and communication. Central banks
have more tools now than six years ago. But when the time comes, they will need the flexibility
to use these tools as needed. And they will have to take decisions with much less certainty than
they would probably like – waiting for irrefutable evidence may complicate exit and prove
costly. The bigger the scale and scope of their interventions, the more difficult it will be to
reduce them.
Long-term interest rates and capital flows Graph 5
Ten-year government bond yield and US term premium
Per cent
Net flows into emerging market funds
12-month moving sum; USD bn
Sources: Bloomberg; EPFR; BIS calculations.
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2013 BIS AGM, General Manager’s speech 8
Beyond the issues surrounding exit, the role of central banks is changing. A monetary
policy framework anchored to price stability remains the foundation for strong, sustainable
growth, but as the crisis has taught us, the goal of near-term price stability must be augmented
with financial stability considerations – including how to deal with financial booms and busts in
a more symmetric way and how to factor international spillovers into decisions. Dealing with
those challenges requires understanding and accepting the limits of what central banks can
and should do.
A shared responsibility
On all reform fronts there has been progress. But everyone has to make the most of the
borrowed time that policy accommodation has provided.
Is this a call for undifferentiated, simultaneous and comprehensive tightening of all
policies? The short answer is no. Concrete measures need to be tailored to country-specific
circumstances and needs. And the timing need not be simultaneous, although in some places it
may be difficult to avoid an overall reduction in accommodation because some policies have
clearly hit their limits.
Ours is a call for acting responsibly now to strengthen growth and avoid even costlier
adjustment down the road. And it is a call for recognising that returning to stability and
prosperity is a shared responsibility. Monetary policy has done its part. Recovery now calls for a
different policy mix – with more emphasis on strengthening economic flexibility and dynamism
and stabilising public finances.
Finally, today’s large flows of goods, services and capital across borders make economic
and financial stability a shared international responsibility. Cross-border effects of domestic
policy action are intrinsic to globalisation. Understanding spillovers and finding ways to avoid
the unintended effects is central to the work of the BIS. And continued discussions among
central banks and supervisors – discussions that the BIS facilitates and promotes – are essential
for avoiding national biases in policymaking. Such national bias runs the risk of undermining
globalisation and thus blocking the road to sustained growth for the global economy.