Sustaining the momentum
Speech by Mr Agustín Carstens, General Manager of the BIS, on the occasion of the Bank's Annual General Meeting, Basel, 24 June 2018.
Ladies and gentlemen, it is my pleasure to welcome you to the presentation of the first ever BIS Annual Economic Report. The first three chapters review global developments, prospects and risks, with particular emphasis on monetary policy and financial regulatory reforms, markets and intermediaries. We also devote two special chapters to topical issues, one on macroprudential frameworks and one on the economic analysis of cryptocurrencies.
My remarks today will focus on the first three chapters. Acknowledging the gains from a decade of reforms and extraordinary macroeconomic policies after the Great Financial Crisis (GFC), I will stress the need for policies to sustain the growth momentum in the face of many uncertainties and risks. After my presentation, Claudio Borio, Head of the Monetary and Economic Department, and Hyun Shin, Economic Adviser and Head of Research, will elaborate on the special chapters.
A stronger global economy ...
Over the year in review, the economic expansion strengthened and broadened. Global growth rates were around their pre-crisis long-term averages, and the expansion took hold simultaneously across countries. The private sector was the main engine of growth, but fiscal expansion also helped in some countries. Unemployment continued to decline, reaching multi-decade lows in a number of economies. Overall, headline inflation rates moved closer to central bank objectives, although core inflation typically remained more subdued. Generally benign financial conditions supported the expansion. The slowdown in the first quarter of this year is mostly considered temporary.
The near-term outlook is largely favourable. Growth is projected to remain high, at least by post-crisis standards. Unemployment is expected to fall further, testing notions of full employment. And investment should pick up, promising to boost productivity over time. Financial conditions remain in general quite supportive, despite some recent tightening, notably in emerging market economies. Moreover, although some countries will be under pressure to consolidate, fiscal expansion will provide additional near-term stimulus in quite a few others.
It is now 10 years since the Great Financial Crisis, and I think that the central banking community should feel satisfied with the state of the global economy today. Much of this is the reward for a decade of supportive macroeconomic policies, aided by unconventional monetary policies. Thanks to central banks' concerted efforts and their accommodative stance, a repeat of the Great Depression was avoided. The historically low, even negative, interest rates and exceptionally large central bank balance sheets during the last decade have provided important support for the global economy and have contributed to the gradual convergence of inflation towards objectives. And major financial reforms - including the recently completed Basel III, a prime example of global cooperation - have strengthened the financial system.
Yet, as central bankers, we should never be complacent. Our job comes with the responsibility to be diligent in identifying vulnerabilities and to act in consequence. Central banks were largely left to bear the burden of the recovery, since other policies, especially supply side structural ones, failed to take the baton. But this has left a legacy of swollen private and public sector balance sheets and higher debts - a legacy that shapes the road ahead. As the global economy reaches or even exceeds potential, it is time to take advantage of the favourable conditions. It is now time to put in place a more balanced policy mix to promote a sustainable expansion. However, the path ahead is a narrow one.
... but with risks ahead
While in the short run there are only limited weaknesses globally - with financial strains in some emerging market economies a key exception - there are material risks ahead. The analysis in the Report highlights uncertainties that could undermine the momentum. Let me expand on a few.
Financial conditions have overall been quite easy in the last few years, especially given the monetary policy normalisation under way and solid global growth. Term premia remain unusually low and credit spreads are very compressed, often close to or even below pre-GFC levels. There are signs of financial cycle-related imbalances in countries little affected by the crisis, following years of private credit growth. Many asset prices are very elevated, notably equity prices in some advanced economies. This includes high house prices in many countries, and highly leveraged households as a result. These patterns partly reflect a decade of unconventional monetary policies. The depreciating dollar in 2017 meant easier financial conditions around the world, especially in emerging market economies. As the Report documents, the loose financial conditions contributed to increased vulnerabilities. In previous episodes, such vulnerabilities have heralded a range of problems, including recessions.
Indeed, the recent tightening of financial conditions, including the still very gradual and largely expected dollar appreciation, has already sparked some stresses. This is particularly visible for the most vulnerable emerging market economies - Argentina and Turkey. Other countries have also been affected, but to a lesser extent. While it is too early to tell whether the strains will remain contained or put more countries under pressure, portfolio investment has been flowing out of emerging market economies.
As the Report notes, most banks' balance sheets have greatly improved and the adjustment to the new, Basel III requirements is basically complete. But improvements are not uniform. In some crisis-affected advanced economies, banks have not fully healed, and business models have not yet fully adapted to the new environment. As a result, some banks' market valuations remain below book value, and some banks' ratings are lower when assessed on a standalone basis, suggesting that relatively small shocks could easily erode confidence. In addition, in some advanced economies, concerns about fiscal sustainability have led to spikes in sovereign spreads, with widespread effects on bank valuations and financial markets more generally.
With these and other vulnerabilities looming, a number of developments could threaten the economic expansion under way. One could be a further escalation of protectionist measures, undermining the open multilateral trading system which has laid the foundation for much of the global progress in improving living standards. Indeed, there are signs that the ratcheting-up of protectionist pressures has already weighed on investment.
Another threatening development could be a sudden decompression of historically low bond yields, a "snapback", in core sovereign markets. A greater share of credit is now intermediated by non-banks, especially asset managers. This means interactions among agents become more complex, with consequences for asset prices and financial stability that can be harder to anticipate. As shown earlier this year, small events, including mild inflation surprises, can easily scare overstretched financial markets. Moreover, as asset management has become more global, international repercussions can quickly multiply.
Another risk is a reversal in global risk appetite, possibly triggered by concerns about some sovereigns' debt sustainability, as happened recently in the euro area periphery. In contrast to the snapback scenario, this could usher in a further compression of term premia in those sovereign markets benefiting from the flight to safety, rather than a widening.
Many of these risks have to be considered in the light of turning financial cycles in some economies and aggregate debt burdens, both public and private, that have continued to increase post-crisis. Turning financial cycles can carry the seeds of risk, including recessions. High public debt is obviously constraining fiscal policy.
The economic upswing also still relies on extraordinary support from central banks. However, central banks may find it increasingly difficult to manage both financial stability and price stability objectives. Their room for manoeuvre is clearly more limited than before the Great Financial Crisis. Interest rates are significantly lower and central bank balance sheets much larger, making easing policies harder. This applies in different ways and degrees to both advanced and emerging market economies. Many of the latter have precious little room for policy mistakes.
Policy challenges
Policy actions today should encourage the establishment of frameworks that avoid the further build-up of risks, promote sustainable growth, and prepare economies to adapt to technological and other structural changes. This calls for policies that have long horizons and that take account of the various interlinkages.
Fiscal policy must ensure that public finances are on a sustainable footing. Compared with pre-crisis, public sector debt in relation to GDP has increased further, leaving very limited space. In this context, the Report notes the dangers of higher debt service burdens as interest rates rise. With due regard for country-specific circumstances, fiscal consolidation over the medium term is a priority in most economies.
Besides implementing agreed financial regulatory measures, maintaining and deepening financial reforms is still necessary. This means further strengthening the resilience of banking systems in both balance sheet and business model dimensions. It's also key to assess and tackle risks in non-banking sectors, including those related to liquidity mismatches and interactions that can lead to adverse effects.
Structural policies have often been lacking during the last decade. Reforms should reinforce the ability of economies to absorb shocks and avoid a further build-up of imbalances. Moreover, they need to encourage workers, employers and consumers to adapt to ongoing structural changes, many triggered by technological advances. In the current political environment, maintaining an open trading system is one of the toughest tasks. But there is no greater need today than to defend the system that has fostered such enormous global gains.
Monetary policy is also crucial when looking over a longer horizon. Monetary policy normalisation among advanced economies is essential in rebuilding policy space, with a focus on enhancing resilience to slow-building threats. This means responding to signs of inflation resurfacing, while not overreacting to moderate inflation shortfalls or transient bouts of volatility. This would create room for countercyclical policy, dilute the risk of financial vulnerabilities, and slow down debt accumulation. For some emerging market economies the adoption of a tighter monetary policy stance might be necessary sooner rather than later, given the likelihood of investors' portfolio adjustments in anticipation of tighter global financial conditions. For these countries, the presence of a congruent macro-financial framework will be of the essence in the period ahead.
As highlighted in one special chapter of the Annual Economic Report, and as Claudio Borio will detail, the role of macroprudential frameworks in ensuring more resilience is now more widely recognised. Reaping the full benefits of this intellectual shift requires embedding an explicit macroprudential orientation to regulation and supervision into broader and more holistic macro-financial stability frameworks. Those must include monetary, fiscal and structural policies. Only such well constructed frameworks can help ensure financial and macroeconomic stability while boosting overall growth on a sustainable basis.
In all of this, it is essential to consider the rapid changes that technological advances have brought about in financial services. As noted in the Report, these include not just fintech but, potentially more importantly, big tech - the foray of the big technology firms into financial services. The latter could erode valuations of incumbents and pose existential threats. We are just seeing the early signs, but we may well be at the cusp of a new paradigm.
While there are many benefits from technological advances, including more efficient financial services, they also signify potential threats to the current monetary and financial system. Some of these new risks stem from the emergence of cryptocurrencies. Cryptocurrencies promise to replace trust in long-standing institutions, such as commercial and central banks, with trust in a new, fully decentralised system. Looking beyond the hype, the analysis in our second special chapter makes it clear that today's cryptocurrencies cannot deliver on these promises. They are impractical as a means of payment, offer a lot of scope for fraud, and entail enormous environmental costs. As the chapter highlights and Hyun Shin will explain, they also have many further economic shortcomings. They have a limited ability to satisfy the signature property of money as a coordination device and to ensure the finality of payments.
The emergence of cryptocurrencies calls for global coordination to prevent abuses and to strictly limit interconnections with regulated financial institutions. The goal should be to ensure that cryptocurrencies cannot undermine the role of central banks as trusted stewards of monetary and financial stability. The decentralised technology of cryptocurrencies, however sophisticated and useful for many other purposes, is a poor substitute for the solid institutional backing of money through independent and accountable central banks.
A four-part agenda
Let me conclude with four goals for policy. First, secure the progress made over the last decade. Second, continue on the path of normalising monetary policy, and normalise gradually, with careful communication, while considering global spillovers and spillbacks. Third, maintain a long-term perspective and limit the build-up of imbalances as part of the design and implementation of holistic macro-financial stability frameworks. Finally, redouble efforts to implement structural reforms to strengthen the global economy's resilience and growth potential.
In sum, we must seize the day. Addressing vulnerabilities is key to keeping the growth momentum on track. The stronger performance gives us a window to pursue necessary reforms and recalibrate policies. Let's not miss this opportunity.
