The Hindu Business Line : BIS' growth mantra

The Bank for International Settlements feels that structural changes are always politically difficult to push through. What is required now, according to its annual report, is primarily the political courage to see the needed reforms through. Will the governments undertake this unpleasant task?

WITH the world economy still anaemic, it confronts a fundamental dilemma of how to redress imbalance in growth and external accounts across the major economic regions, while maintaining robust growth overall.

How this dilemma can be resolved and economic growth impulses triggered in a deflationary milieu is a challenge and the attempts to answer it are being broadly articulated in this year's annual report released on Monday by the Bank for International Settlements (BIS), the central bankers' central bank.

The Basle-based BIS points out in this year's annual report that the prospects for growth in the near future would be actuated by two underlying economic parameters — the propensity to save and to take risks.

The BIS says that what supervenes to the propensity to save in the US is of particular relevance as the country has been a disproportionately large source of global demand growth for almost a decade.

The secular decline in the household financial savings rate in the US has been remarkable and similar declines have been seen in a number of other countries. In Asia, where saving rates have also waned but generally remained much higher, reliance has commonly been put on export-led strategies to sustain demand growth.

But maintaining such strategies in the face of rising saving rates elsewhere would clearly inhibit global growth overall, the report says, adding "given such an environment, with inflation levels already low, it is not inconceivable that problems of more generalised deflation might also emerge".

A second factor shaping near-term prospects would be investor attitudes towards risk. Thus, on the one hand, improprieties in corporate governance have caused financial reports to be viewed with deep suspicion.

The report highlights how the global financial markets suffered extraordinary blows to confidence last year with a series of corporate governance improprieties, the most prominent of which was a financial restatement by the US telecommunications firm, WorldCom, in late June 2002, heightened risk premia across financial markets.

As a result, equity markets too suffered deeper losses in 2002 than during the previous two years. In the light of past losses of capital, the vulnerabilities of risk-seeking financial institutions are now better appreciated. These changing attitudes seem likely to reduce the willingness of both creditors and debtors to take on risk and could restrain the expansion.

Even as these two underlying factors remain important, what could be said with much greater certainty is that longer-term prospects for more balanced growth would depend, in part, on policy changes in those industrial economies with deep-seated structural problems.

Related issues affects a much broader range of countries, the BIS says adding that the opening-up of production methods, has already led to startling productivity increases and downward pressure on goods prices. This is proving to be a discomfort to many established goods producers worldwide, albeit providing sales outlets to many others.

The implication is that the secular shift towards a service-based economy in the industrial world must now accelerate. Unless job opportunities are created in new sectors, or wages adjust sufficiently, this would lead to a lingering increase in unemployment. Nor is the adjustment problem limited to the industrial world.

In East Asia, for instance, countries must adapt to the growing importance of China, with a liberalising India perhaps not far behind. The report rightly stated that they too have "unresolved financial problems dating from the last decade which could make lenders hesitant to underwrite these necessary changes".

In what is clearly a prescription, the BIS contends that the need to be able to respond flexibly to prospective developments has never been greater — all the more so since the alternative might be "a relapse into protectionism". Here the report voiced concerns over "the limited progress made to date in the Doha round of trade negotiations and by various transatlantic frictions".

As deflationary pressures and the need for painful adjustment to post-bubble realities would further aggravate such insular tendencies, BIS says policy-makers need to be reminded of two things. As the report put it picturesquely, "since we are all in the same economic boat, more cooperation is needed at the national level — between monetary, fiscal and prudential authorities — and at the international level as well".

Second, quick fixes almost always have longer-run costs as well shorter-run benefits. Hence, policy frameworks that blend the capacity to respond flexibly to short-run difficulties with sustainability over the medium-term thus have a great deal to recommend them.

Dealing with micro issues, the BIS argues that compared to the concerns associated with possible further economic weakness, other financial vulnerabilities looking forward seem less worrisome. One set of concerns, which has received attention in connection with the New Basel Capital Accord, pertains to operational risk in the financial system. A second set of concerns has to do with increased volatility in financial markets, and the possibility that some financial institutions might have insufficient means in place to protect themselves.

The report makes an interesting point in that the stability of the financial system to date has commonly been ascribed to its having become a more market-oriented system. In the US, in particular, the share of total lending provided by banks has shrunk dramatically.

Markets are more complete in that they now offer borrowers a growing diversity of channels through which financing can be obtained. By the same token, they also seem more resilient. Losses are now more widely spread across the financial markets, most recently through the growing use of instruments for credit risk transfer.

The fact that shocks are shared across interrelated markets might also make them easier to absorb. But it would be `naïve' to suppose that this system is free from foibles. "The fact that borrowers can go through a wide variety of channels to obtain credit could easily tempt them to overextend them", it said noting that this would appear especially likely of credit originators dispense with due diligence, on the assumption that even bad loans could be passed on via market mechanisms to someone else. Rightly, the BIS report says that interrelated markets might dampen shocks on the one hand, but they may, on the other, expose already troubled sectors to new difficulties sufficient to push them over the edge of insolvency.

In short, the report unequivocally underlines the fact that a reasonably satisfactory performance to date should not lull us into complacency about financial stability.

In this context, the BIS report poses the point that regardless of whether problems of financial instability are assumed to be permanent or only temporary features, how to lower the likelihood and costs of such disruptions remains an important policy issue.

One possibility that has been widely debated is that monetary policy might be used pre-emptively to moderate credit cycles. Another option might be to put more reliance on the prudential framework. Alongside, the institutional underpinnings of the financial system require further strengthening.

The recent agreement to work towards a compatible set of international accounting standards awaits implementation. National oversight boards for auditing firms, operating subject to internationally agreed principles, need to be established. And conflicts of interest in the governance structure of firms, in general, but financial firms, in particular, should be identified and dealt with.

The world's central bank pertinently says that "if trust in the integrity of the capitalist system is crucial to its proper functioning, then it is important that wrong-doers are punished and are seen to have been punished. Given the flagrant excesses of recent years, it is by no means clear that enough has yet been done to re-establish trust in the system".

BIS is of the view that structural changes — whether on the economic or financial side — are always politically difficult to push through and adverted to the recent statements by governments in both Asia and Europe which indicate clearly that they are very much aware of the benefits of structural reforms.

What is required now, according to the report, is primarily the political courage to see the needed reforms through. Will the governments undertake this unpleasant task of reining in rising fiscal deficit, stimulating the economy and maintaining financial and monetary stability, remains a moot point even as the world's central bank fervently hopes so.

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