BIS Annual Report

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

http://observer.guardian.co.uk/business/story/0,6903,992232,00.html

Sinking US dollar 'could drag world under'

The Bank of International Settlements fears a deflationary crisis
because the global economy is too tied to America.
William Keegan reports
Sunday July 6, 2003
The Observer

Unless the leading industrial countries get their act together and
pursue compatible economic policies, the world economy may be threatened
by 1930s-style competitive devaluation and an outbreak of protectionism.

This warning comes from the Bank for International Settlements (BIS),
one of the world's most prestigious international financial institutions.
In its authoritative annual report, the BIS warns that: 'The global
economy faces a fundamental dilemma, which is becoming more acute with
time. How can imbalances in growth and external accounts across the
major economic regions be resolved while maintaining robust global
growth overall?'
The bank suggests that the rest of the world has been far too dependent
on the economic stimulus provided by the United States and that the
ongoing decline in the dollar is going to make life much more difficult
for Europe and Japan.
The report warns that unless other countries supplement fashionable
'structural reforms' with 'more expansionary demand management policies'
there must be a question mark over 'whether domestic demand will expand
elsewhere, notably in continental Europe and Japan, after a long period
of weakness'.
Known as 'the central bankers' bank', the BIS, headed by Malcolm Knight,
is involved with banking and other financial regulation and has a
particular concern about the dangers of systemic weakness in the world
economy.
It says that 'the institutional underpinnings of the financial system
require further strengthening' and expresses grave concern about the
erosion of trust in financial markets. 'If trust in the integrity of the
capitalist system is crucial to its proper functioning,' says the BIS,
'then it is important that wrongdoers are punished and are seen to have
been punished.'
From its position as a central observer of the regulatory effort, the
BIS plainly believes that some financial operators have been getting
away with murder. '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,' it comments.
The central bankers' bank points to the large overhang of industrial
excess capacity in the US from the earlier boom, with capacity
utilisation at a 20-year low and debt levels still high, and argues that
the current level of Wall Street 'can only be justified by expectations
of an economic rebound and sharp increase in profits'.
The BIS highlights the fact that, although devaluation of the dollar is
a necessary part of the current adjustment process (ie, making American
exports more competitive and lessening US dependence on foreign funds to
finance its imports) 'about half of the US current account deficit today
is concentrated in countries whose currencies have closely tracked the
dollar'. The main culprit here is China, which, by maintaining its link
with the dollar, has now become supercompetitive in international trade.
The BIS warns that this adds to the upward pressure on the yen and the
euro. The implication is that the European Central Bank, and individual
European governments, should be doing more to boost domestic demand. In
which connection it is noteworthy that the German government is now
bringing forward tax cuts originally designated for 2005, and Chancellor
Gerhard Schroeder last week dropped heavy hints to the ECB that it
should ease further.
It is especially interesting - and disturbing - that the BIS is so
concerned about the threat of deflation. Central bankers are
traditionally more concerned about inflation, even when it is at
comparatively low levels. A schism has now opened up in central banking
circles, with the Federal Reserve and the BIS worried about deflation,
but Wim Duisenberg, the retiring president of the ECB, still issuing
warnings about the 'need' for Germany and other countries to adhere to
the Stability Pact.

In this context it was interesting that Sir Edward George, in his recent
retirement interview with The Observer, indicated that he thought
'structural reform' was not enough to resolve continental Europe's
economic difficulties and that active measures should be taken to expand
demand. (George was also, until last week, chairman of the high-powered
Group of 10 leading central bankers that meets most months under the
auspices of the BIS in Basle.)

The BIS states: 'One of the most daunting challenges faced by central
banks in a deflationary environment is the zero lower bound constraint'
- the fact that interest rates cannot fall below zero, thereby weakening
the effectiveness of monetary policy.
As the BIS concedes: 'There are limits to the effectiveness of monetary
policy.' It calls upon central banks 'to explore systematically, along
with fiscal and prudential authorities, the set of policy options
available to address deflationary forces well in advance of their actual
emergence.'
The bank acknowledges that such an approach would involve 'co-ordination
of policies across separate institutions' and might raise questions
about central bank independence. But it emphasises that the issue is too
important to ignore: 'This risk could be worth bearing if the
exploration of such options helped to inspire confidence in the ability
of the central bank, and policymakers as a group, to fight deflation.'
Implicit in the BIS's remarkably frank admission of its concerns is a
historic acknowledgement by the kings of Central banking that the
once-fashionable monetarist belief in price stability as the great
economic panacea has proved seriously defective.
Referring to 'excessive optimism and credit expansion, asset price and
spending bubbles, and balance sheet problems that subsequently rebounded
on the financial system' the BIS concludes: 'Clearly, the achievement of
price stability, with its unquestioned merits, has not been sufficient
to ensure the avoidance of financial instability.'
That, in central bankers' speak, is quite an acknowledgement.

Guardian Unlimited ?Guardian Newspapers Limited 2003



30 June 2003

"The global economy lost steam in the course of last year despite
significant policy stimulus," said the Bank for International
Settlements (BIS) in its Annual Report

73rd Annual Report 2002/03: an overview

I. Introduction: an uncomfortable soft spot

As the Annual Report went to press, improved confidence in financial
markets was beginning to be reflected in surveys of business confidence
but there was no clear evidence of a decisive improvement in
macroeconomic trends. The global economy once again failed to make the
transition from hesitant recovery to robust expansion during the period
under review. Growth in most of the large industrial countries failed to
meet earlier expectations, in spite of ample policy stimulus, with much
of continental Europe showing particular weakness. Consumer spending in
both industrial and emerging markets held up relatively well, but
corporate investment remained weak given an overhang of debt and excess
capacity which weighed on profits. Disinflationary forces were evident
almost everywhere, and deflation either emerged or threatened in a
number of economies.

The financial vulnerabilities that might have been expected in such an
economic environment remained muted, even if some strains did emerge.
With the exception of Japan, banking systems in major countries appeared
quite robust although insurance companies and pension funds generally
suffered as a result of lower equity prices. Until late in 2002, capital
markets were virtually closed to lower quality credits, including some
sovereigns, but have recently become much more welcoming.

II. Developments in the advanced industrial economies

Despite significant policy stimulus in the advanced industrial
economies, output recovered only modestly in 2002. Household spending
remained resilient, supported by rising property prices and buoyant
mortgage refinancing in several countries, while firms continued to
scale back investment. In addition, heightened concerns about
developments in the Middle East probably held back the expansion in the
most recent past. The recent improvement in profits and continued
technical progress have created favourable conditions for a revival in
capital spending. Yet repairing corporate balance sheets is a slow
process and may require further deleveraging. The household debt burden
has risen in recent years, suggesting that household saving rates may
now begin to rise as households seek to rebuild assets following
substantial past declines in their financial wealth.

Recent economic developments have underscored many important policy
challenges. The United States had a pivotal influence on global growth
in 2002, partly because of significant longer-term weaknesses in some
other major countries and regions. Inflation has remained moderate but
downward pressures on the prices of goods worldwide have prompted some
to focus on the dangers of global deflation. The deterioration in fiscal
balances and the prospect of ageing populations in many industrial
countries highlight the need for maintaining confidence in the long-term
sustainability of fiscal positions, particularly as fiscal rules have
been effectively relaxed. A final issue is the widening of current
account imbalances observed in recent years. This has reflected major
shifts in the position of countries or regions as suppliers or users of
saving. While lower fiscal deficits in the medium term would be helpful,
a sustainable reduction in the US current account deficit may also need
to be associated with a higher household saving rate in the United
States and higher levels of demand in other countries.

III. Developments in the emerging market economies

2002 was marked by sharp divergence in the growth rates of emerging
economies, with growth in Latin America being particularly weak. In
2003, growth prospects in Asia have been hurt by the spread of the SARS
virus; the economic outlook for Latin America has brightened as exports
have rebounded following large real currency depreciations and improved
external financing conditions. Growth is also expected to rise in
central Europe and Africa in 2003.

The chapter reviews the policy challenges confronting emerging economies
in each major region. The first is the feasibility of growth-supporting
macroeconomic policies in Asia. Favourable investor sentiment allows
some scope for expansionary fiscal policies in the short run, even if
ratios of public debt to GDP are comparatively high. But continued debt
accumulation over the medium term in a number of countries could create
difficulties. In addition, the easing of monetary policy in a number of
Asian economies has been associated with a property market boom and an
overly rapid growth in household credit. Secondly, there are the policy
dilemmas created by external financing constraints in Latin America. In
2002, sovereign spreads for Latin American and other heavily indebted
economies widened, capital inflows dried up, currencies depreciated and
inflation rose sharply. Policymakers sought to reassure investors by
measures of fiscal consolidation and reform. In formulating monetary
policy, policymakers had to set interest rates high enough to curb
inflation, but low enough to keep the economy growing and reassure
investors that debt would be serviced. The policy challenge for central
and eastern European countries is eventual EMU membership. Excessive
budget deficits have contributed to high interest rates in some
countries that have attracted large capital inflows, creating dilemmas
for the monetary authorities.

IV. Monetary policy in the advanced industrial economies

Monetary policy was stimulative in industrial economies during the
period under review. This was due, in part, to the tepid recovery in
2002 and, in part, to risks of a sharp downturn in economic activity in
an environment of heightened uncertainty. In the United States, the
Federal Reserve held its policy interest rate roughly steady at a low
level for most of the period, as prospects for a robust recovery
remained in doubt. The ECB initially held rates steady at a higher
level, as inflation remained a concern, but eventually cut them as
growth slowed unexpectedly. Persistent economic weakness in Japan
prompted the monetary authority to intensify its policy of quantitative
easing. Conditions were more mixed in countries with explicit inflation
targets, with some central banks tightening rates in the face of rising
inflationary pressures.

The risk of deflation became a concern during the period under review.
With the attainment of a low-inflation environment, the stalled global
recovery has raised the possibility, however remote, of generalised
deflation. Deflation presents a challenge for monetary policy because it
can be very disruptive, especially when accompanied by sharp asset price
declines. Deflation can also constrain the effectiveness of conventional
monetary policy as nominal interest rates approach the zero lower bound.
A special section of the chapter examines past episodes of deflation,
focusing on the 19th and early 20th centuries.

V. Foreign exchange markets

The weakening of the US dollar was the salient feature in the foreign
exchange markets during the period under review. By mid-May 2003, the
dollar had fallen from its early 2002 peak by around 25% against the
euro; the movement against the yen was some 12% over the same period. In
nominal effective terms, the dollar lost about 16%. Against the backdrop
of disappointing growth prospects and the continuing decline in equity
prices, interest rate differentials seemed to re-emerge as an important
factor behind exchange rate movements. In addition, concerns about the
growing US current account deficit weighed on the dollar. Changes in the
composition of the deficit suggested a rising risk premium on US assets.

A historical review of major current account reversals in a large number
of industrial countries since 1973 reveals that these adjustments were
associated with slower domestic growth but only relatively minor
currency depreciations. In contrast, an analysis of the US current
account adjustment around 1987 indicates that the decline of the dollar
played a much larger equilibrating role. Yet there are also important
differences between current conditions in the global economy and those
that prevailed in the 1980s. This implies that a similar pattern of
dollar adjustment cannot be predicted with confidence, even though a
significant correction of current account imbalances still seems likely.

Several non-EMU European currencies, as well as the Australian, Canadian
and New Zealand dollars, derived support from their interest rate
differential over US dollar- or euro-denominated assets. The
appreciation of these currencies also seemed to be underpinned by the
relatively good performance of the respective economies. By contrast,
the appreciation of the Swiss franc between January 2002 and March 2003
mainly reflected the currency's traditional safe haven role, which to
some extent offset the Swiss National Bank's policy ease. Nonetheless,
following the monetary easing in early March 2003 and the attenuation of
geopolitical tensions, the Swiss franc depreciated against the euro.

The search for yield by international investors also lent support to
some emerging market currencies during the period under review, although
global economic prospects and various domestic factors also exerted a
considerable influence.

VI. Financial markets

Global financial markets suffered extraordinary blows to confidence
during the period under review. 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
suffered deeper losses in 2002 than during the previous two years. Even
the once resilient corporate bond market experienced an episode of
severe dislocation. Volatility in the major financial markets spilled
over into emerging markets, with global investors' changing appetite for
risk appearing at times to dominate local developments.

As investors regained confidence, markets staged rallies starting in
October 2002 - first the corporate and emerging bond markets, and later
the equity markets. Corporate efforts to strengthen balance sheets
underpinned a narrowing of credit spreads in late 2002. While lower
yields in government and swap markets indicated some questioning of this
confidence, it did help to extend the rally in credit markets. Even
traditionally conservative investors appear to have sought higher
returns in corporate and emerging market bonds. In spring 2003 equity
markets joined the rally, buoyed by the rapid end to the war in Iraq and
by encouraging earnings reports.

Housing markets continued to show remarkable strength more than three
years after equity market prices peaked. In the past, housing prices had
tended to turn down around two years after an equity market peak. One
explanation is that, in recent years, central banks have been able to
cut policy rates sharply, thus supporting housing prices. In the past,
by contrast, the monetary authorities had often raised interest rates in
an effort to restrain aggregate demand and inflation.

VII. The financial sector

Financial systems in industrialised countries came under additional
pressure last year, as expectations of an early economic recovery were
dashed and equity prices fell further. Nonetheless, financial
institutions generally appeared to weather the economic downturn
successfully, and financial sector pressures did not impede the supply
of credit in most countries. Banks generally displayed considerable
resilience, reflecting both atypical aspects of the current cycle (eg
accommodative monetary policy, growth in household expenditure and the
absence of a property price bust) and structural factors (eg the use of
financial instruments that facilitated the wider dispersion of credit
risk across the financial system). Nevertheless, some sectors were
confronted with difficult challenges. The Japanese financial system
continued to face problems of non-performing loans and low profits. The
performance of German financial institutions was weak, due as much to
long-standing structural weaknesses as to cyclical influences. Insurance
companies generally fared less well than banks, as losses on their
investment portfolios and low returns on fixed income assets put
considerable pressure on earnings.

Looking ahead, the primary risks to financial institutions are related
to the macroeconomic outlook. A prolonged period of economic weakness
would further test the loss absorption capacity of financial
institutions and markets. In addition, some firms may face legal and
reputational risks related to activities undertaken during the late
1990s expansion, and the increased role of markets for credit risk
transfer may yet pose challenges for participants.

The recent resilience of the financial sector can be viewed as an
indication that financial systems with multiple channels of funding,
through both market-traded instruments and balance sheet intermediation,
may provide a more flexible response to adverse economic developments.
Nevertheless, such multichannel systems also pose new challenges for
prudential supervisors due to the greater complexity of individual
institutions and of the links between institutions and markets.

VIII. Conclusion: towards more balanced global growth

The world economy faces a fundamental dilemma: how can imbalances in
demand and in external accounts be resolved while achieving solid global
growth performance? A particular uncertainty is whether the global
corporate sector, still preoccupied with strengthening balance sheets
after earlier excesses, will increase investment. This is crucial as
household spending could weaken given rising consumer debt levels,
potentially weaker housing prices and rising unemployment.

Monetary and fiscal stimulus in several countries (especially in the
United States) is providing near-term support, but this could exacerbate
existing imbalances, such as external deficits and historically high
asset valuations in some markets. To ensure the sustainability of a
truly global expansion, more needs to be done to strengthen domestic
demand growth in countries with healthy external balances. In Asia, this
implies allowing currency appreciation and eschewing export-led
strategies for growth. In continental Europe, it primarily implies
implementing the structural reforms that will allow the industrial
sector to respond flexibly to a stronger euro.

Prudent policymakers should be prepared to address the possible
implications if growth were to falter. First, there could be
repercussions on the financial system. Efforts are required to further
strengthen the underpinnings of the financial system, and to ensure that
the risks attendant on greater reliance on markets are being properly
managed. A second concern has to do with the possibility of deflation,
which could constrain the effectiveness of conventional monetary policy
as nominal rates approach the zero lower bound. The efficacy of
macroeconomic measures could, in such extreme circumstances, depend to
an unusual degree on cooperation between the monetary and fiscal
authorities. In addition, the lesson of recent Japanese experience is
that macroeconomic stimulus might have to be accompanied by structural
measures to force companies and banks to adjust to market realities.

Activities of the Bank

This chapter summarises the various activities of the BIS over the past
year: consultations on monetary and financial matters; the standing
committees that meet regularly at the BIS; and the provision of
financial services to central bank customers. In line with its
increasingly global focus, the Bank opened a Representative Office for
the Americas in Mexico City in November 2002.

The bimonthly meetings of Governors of BIS member central banks remained
at the heart of the Bank's contribution to international cooperation in
2002/03. In addition, various meetings were organised throughout the
year on issues of central bank interest, in some cases with the
participation of a broad range of senior non-central bank and private
financial sector officials.

As part of its efforts to promote financial stability, the Bank
continued to host and assist the secretariats of the Basel Committee on
Banking Supervision, the Committee on the Global Financial System and
the Committee on Payment and Settlement Systems. These committees are
charged with reviewing basic aspects of the functioning of international
financial markets and financial institutions. A project of prime
importance is the development of a new framework for bank capital
adequacy (the New Basel Capital Accord, also called "Basel II"), which
is expected to be finalised by the end of 2003. Spreading understanding
of the New Accord was a major area of emphasis of the activities of the
Bank's Financial Stability Institute and is expected to remain so for
the next year.

Through secretariat support and, in some cases, direct involvement in
the deliberations, the Bank continued to assist the work of a number of
independent organisations that have established their secretariat at the
BIS. They include the Financial Stability Forum, the International
Association of Insurance Supervisors and, since May 2002, the
International Association of Deposit Insurers.

The Bank continued to serve as a counterparty to central banks in their
financial operations, and to provide agent and trustee functions for a
variety of financial transactions. In the course of the year, the
balance sheet remained strong, while underlying profits showed mild growth.

Among the key administrative matters marking the past financial year,
special reference should be made to the adoption of the Special Drawing
Right as the Bank's new unit of account, and to the amendment of the
Bank's accounting policies with a view to providing a better picture of
the Bank's financial position and performance.

http://www.bis.org/events/agm2003/ar2003o.htm