Central banks warn of new crisis if exit left too late

Unemployment in EU As soon as the G20 conference at Toronto ended with the US and the EU declaring their views on recovery do not conflict with each other, the BIS – the Bank for International Settlements – struck a different note telling that the governments must cut their budget deficits decisively and Central Banks should not wait too long to raise borrowing costs as side effects from measures stipulated to tackle global recession may invite next crisis. The global economy as well as financial markets were on the mend, though the recovery remained fragile in the advanced economies and in the euro zone the debt crisis put the recovery at risk, the BIS said in its annual report, published on Monday. Though the US president Mr Obama has warned against cutting too fast stating that it would put recovery in danger, global leaders who met in Toronto last weekend have agreed to take different paths for cutting budget deficits and not to impose global tax on banking system. Now the BIS seems to be siding with the EU, as its head warns there remains no time to waste.

"We cannot wait for the resumption of strong growth to begin the process of policy correction," BIS general manager Jaime Caruana told the bank’s annual general meeting. "In particular, delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress" Caruana added according to Reuters. Caruana later acknowledged in a news conference that recently announced fiscal consolidation in some countries together with the publication of bank stress tests in Europe and the support of the G20 for regulatory reforms were important steps forward. As a bank to central banks and a discussion forum for policy makers the BIS said reforming the financial system is the most important to prevent further crises. Caruana said the benefit of making the financial system more resilient through tighter regulation outweighed any short-term growth losses.  

Top central bankers met at the BIS annual meeting June 26-28 in Basel, following the G20 summit where leaders acknowledged the uneven and fragile economic recovery in many countries. The countries of ‘Group of 20’ acted in unity in the past three G20 conferences that were held in the back drop of an unprecedented global financial crisis since ‘the great depression’. In contrast the latest G20 meeting at Toronto has seen the leaders leaving room to move at their own pace and adopt “differentiated and tailored” policies. But the BIS warned powerful support measures had strong side effects and said their dangers were starting to emerge. "To put it bluntly, the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse," the BIS report said.

The BIS said if fiscal supporting measures are kept in place for too long the banks or companies would be left dependent on direct support for survival which cannot be sustained. But it acknowledged the tricky situation for policymakers as the stakes were high and the risks from capping lifelines too early loomed large. Central banks especially were walking a fine line. The banking system was still far from sound, as recent profits from fixed income and currency trading and the low interest rate environment were hard to repeat and not all crisis-related losses may have been booked. "But the longer that policy rates in the major advanced economies remain low, the larger will be the distortions they create, both domestically and internationally," the BIS said. Extremely low real or inflation-adjusted rates altered investment decisions, postponed the recognition of losses, increased risk-taking in the search for yield and encouraged high levels of borrowing, the BIS said. In addition, central bankers may underestimate inflation risks as the crisis may have lowered potential growth rate.

Markets have pushed back expectations for rate increases in the United States and in the euro zone in the wake of the Greek debt crisis, and central bankers urged Europe to solve the crisis so as not to endanger uneven global recovery. Speaking to Reuters on Monday, Jassim Al-Mannai, director general of the Abu Dhabi-based Arab Monetary Fund, said banks and policymakers had to beware of fuelling bubbles. "We have to avoid, every economic authority, not to see bubbles. Our economic policy needs to be prudent, especially monetary and even fiscal policy," he said. Challenges for emerging economies were different as they were recovering strongly and inflation was picking up, the BIS said. "Some EMEs could rely more on exchange rate flexibility and on monetary policy tightening," the BIS said. The Greek debt crisis had highlighted that many governments had to consolidate their finances immediately as highly indebted countries would not be able to rescue banks as a buyer of last resort in another crisis.

Source: Reuters, 28/06/2010.


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