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June 29, 2014 12:52 pm
When the Bank for International Settlements’ chief economist warned in 2003 that dangerous imbalances were building up in the financial system, leading policy makers at the US Federal Reserve’s Jackson Hole symposium brushed the words aside.
The advice of Bill White and his deputy who has now succeeded him, Claudio Borio, to raise interest rates to counter the threat of a market-spun economic crisis went unheeded as policy makers focused on supporting growth.
In its 2014 annual report, released on Sunday, the BIS hints at similar dangers to the ones that eventually emerged five years after the Jackson Hole address, when the collapse of US bank Lehman Brothers pushed the financial system to the brink of implosion.
Central bankers once again are being urged by the BIS to head towards an exit from their extraordinarily loose monetary policies. “The risk of normalising too late and too gradually should not be underestimated,” the BIS report said.
By bowing to political and financial pressure to delay exit, central banks could eventually find themselves boxed in by fears of a sharp market reaction, the BIS warned.
It added: “A vicious circle can develop. In the end, it may be markets that react first, if participants start to see central banks as being behind the curve.”
Whether or not central banks such as the Fed and the Bank of England will follow the latest advice is far from clear. The BIS, based in Basel in Switzerland, is known as the central bankers’ bank – most of the world’s major monetary authorities have accounts there.
But its views on the global economy are often at odds with many of the 60 central banks that they represent. It has repeatedly cautioned its members that their response to the financial crisis – to slash interest rates to record lows and embark on mass bond buying – risks sowing the seeds of the next crisis, if it is not accompanied by structural economic reforms by governments.
That the BIS view contrasts so much with that of their member central banks owes much to differences in the way they look at the global economy. The BIS view espoused by Mr Borio and his team has tended to place more weight on balance sheets, viewing trends through the prism of developments in credit conditions.
How the world’s central banks are addressing global economic uncertainty
It argues that policy makers have collectively failed to get to grips with financial cycles that play out over periods of 15-20 years, rather than the usual eight-year lifespan of the business cycle.
By overreacting to short-term developments in output and inflation, central banks are stoking up bigger problems down the road, meaning policy has become “asymmetrical” – prioritising rescue operations from downturns over efforts to dampen booms.
The latest dangers the BIS has spotted are by no means confined to the advanced economies that have led the dash for monetary and fiscal stimulus.
Corporations in a number of emerging markets, including in Asia and Latin America, have borrowed heavily through their foreign affiliates in the capital markets, with the debt denominated mainly in foreign currency, according to BIS research. This represents a “hidden vulnerability” as companies face the risk that their funding could evaporate at further signs of trouble.
A number of emerging markets are seeing “outsize” financial booms that could turn to bust. The BIS’s early warning indicators single out China among those countries suffering from the risk of a domestic banking crisis, based on the gap between credit and GDP and its debt service ratio.
“Particularly for countries in the late stages of financial booms, the trade-off is now between the risk of bringing forward the downward leg of the cycle and that of suffering a bigger bust later on,” said the report.
The BIS’s warnings about financial risks just over a decade ago were parried by central bankers, including Alan Greenspan, then Fed chairman. His successor, Ben Bernanke, said the experience of Japan, blighted by too-low inflation and stagnant growth, showed higher borrowing costs were no way to prick bubbles in asset prices.
Time proved the BIS’s fears in 2003 to be correct. If its claims prove as prescient this time around, then the current climate could prove the calm before a new financial storm.
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