The room for policy maneuvers is more limited than before the global crisis

The Bank for International Settlements (BIS) points out that even if the global economy successfully overcomes the existing threats in the short term, it could still find itself in trouble.

In its flagship Annual Economic Report, the BIS describes the present condition of the global economy, characterized by economic growth and continued low inflation. This is to a large extent a result of the post-crisis, accommodative monetary policy, which also contributed to the build-up of financial imbalances.

The BIS warns that the good conditions in the financial markets in recent years may have lulled the investors into a false sense of security. Ten years of unusually low interest rates and the large scale asset purchase programs pursued by major central banks around the world may have led to a situation where many financial market participants are insufficiently prepared for changes in the global markets that are coming along with the economic and political decisions taken by global leaders.

Extreme levels of debt

The BIS draws attention to the risks threatening the global economy. A significant increase in the level of global private and public debt is a particularly alarming fact. Because the links between the financial and the economic cycles are becoming increasingly strong, this could amplify the periods of boom and bust.

In 2017 the total global debt increased by 14 per cent, reaching USD174 trillion. The level of debt in relation to GDP remains particularly high in developed economies — at 269per cent, but emerging markets are not far behind. The total level of global debt is equivalent to 217 per cent of the global GDP.

The prevailing low interest rates are encouraging further borrowing. According to the authors of the BIS report, the continuing good market conditions contribute to the search for higher rates of return and the pursuit of more risky investments in assets bearing higher interest rates (e.g. in emerging markets).

The BIS warns against risks to financial stability arising from such activities. The main risk is that of a sudden change of the historically low yields in the major sovereign bond markets, for example in response to an inflation reading that would force the Federal Reserve to accelerate the pace of monetary policy tightening.

A reversal in global risk appetite among investors, which may lead them to look for safe assets, is another threat. The investors could pull their capital out of emerging markets, which would significantly worsen the situation in these countries.

This could be triggered, among other things, by concerns about the stability of the level of indebtedness of some countries or about the escalation of protectionist measures – which seems increasingly likely based on the observation of the current rhetoric and activities pursued by the administration of the United States in the area of trade policy.

Reforms in the real economy

The BIS indicates that although there are limited ways for achieving long-term sustainable economic growth based on price stability and financial stability, an appropriate set of economic policies could nonetheless help to minimize and counteract significant threats.

The key lies in structural reforms and the restoration of necessary room for maneuvers in monetary and fiscal policies, in order to be able to respond to future threats, as well as the full implementation of the post-crisis regulatory reforms. Structural reforms are a priority, because they allow for making the labor and product markets more flexible, and therefore contribute to a better allocation of resources. This category also covers the defense of free trade.

The second line of action is to strengthen the resilience of the financial system, if necessary with the use of macro-prudential tools.

The third line of action is to ensure the sustainability of public sector finances and to avoid pro-cyclical fiscal expansions. Moreover, it is necessary to continue with the normalization of the monetary policy — at the same time the BIS comes out in favor of a more balanced combination of activities, in which the fiscal policy “relieves” the central banks.

The BIS positively assesses the condition of the financial sector — most banks are now better capitalized thanks to the adaptation to the new requirements of Basel III. The BIS also points out that the ability to predict the reactions of the financial market may be hindered by the growing role of non-banking institutions in financial intermediation, and in particular in the asset management sector.

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