The oldest multi-governmental financial institution, the Basel-based Bank for International Settlements, publishes one of the most authoritative overviews of the financial system’s state of play in the form of its annual report. This year’s report was published in late June. Although the banking system remains central to its work, in view of the intertwining of bank and capital markets financing and trading, for some decades now the two components have grown ever more inseparable. Both now figure at length in the report.
Once each year, it is good to set aside one’s usual short-term and rather local focus to step way back and have a look at the broad picture. The data and texts result from compiling inputs from nearly all of the world’s central banks.
For Thomas Murray and its clients, work and planning must address this global context looming over what we do, be it the risk managers or the business strategists. It is fair to say that for the world’s central bankers, the global financial system is always a work-in-progress, with one or more elements or aspects out of line. Yet the use of the adjective “overstretched” is striking, and meant to be: it is incumbent upon actors in this system to pay heed to the remarks and priorities set out as the central bankers’ common agenda, because reforms and policies set by the world’s central banks in some manner come back to affect us all. Or something may go wrong before the remedy is in effect.
Indeed, not all misalignments get handled promptly or effectively, for reasons that go well beyond this posting: throughout the 2000s, the BIS annual report expressed deepening concern about the potential for damage to the global system from OTC derivatives contracts, backed by the statistics the bank was gathering from its central bank members. With the task of continuing to resolve this thorny problem coordinated for the G20 by the Financial Stability Board since the Global Financial Crisis, one can say that the original question may have changed scale and shape, but it still bedevils the overseers.
The dictionary defines “overstretched” as: “something on which excess demands are being made.” Taken literally, the world’s central bankers are collectively saying that the global financial system is not the right size or shape to meet the needs of the world’s economy, a daunting thought suggesting that something significant may well pull back or snap. Knowing how very carefully crafted the text is each year, and how attentive central bankers have to be with their choice of words, the use of as an adjective this forceful has to be understood as voicing a considerable concern:
"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.
An escalation of protectionist measures or a sudden jump in historically low bond yields in core sovereign markets could trigger a fresh downturn. Political upheavals or disappointing profits could dent investors' appetite for risk, shaking overstretched financial markets…”
Other highlights from the report
Through the voice of the BIS, the world’s central bankers saluted the pick-up in global growth rates over the prior 12 months, somewhat above the expectations of a year earlier. Moreover, in many countries the inflation rate and the unemployment rate together remained unusually low. The cyclical upswing of the previous few years gained strength and geographical balance. Good growth is a source of tremendous relief and satisfaction to central bankers and other economic planners, though the BIS and its members remain keen to investigate the nature and balance or imbalance of that growth.
The key challenge now is to sustain the higher growth beyond the near term. So far, the recovery has been too dependent on central banks' actions and unconventional policies, leaving some problems in its wake. Financial vulnerabilities have been rising. Financial markets appear overstretched. In some economies, credit has expanded strongly, often alongside large property price increases and sometimes heavy foreign currency borrowing. Globally, aggregate total non-financial debt has risen further relative to income. The room for fiscal and monetary policy manoeuvring is more limited than pre-crisis and, partly because policy has failed to address structural impediments, long-term potential growth rates are lower. And more recently, increasing protectionist pressures have challenged the international trade system that has buttressed global growth post-WWII. All this suggests that downside risks to growth are material, as has recently been confirmed by financial strains in some emerging market economies. So generally a good recovery, but uneven and fragile.
The key policy question of the report, then, was how to use the relatively benign current conditions to correct areas still in need of improvement to return to a better balance, with a wary eye to the future and what might go wrong before proper repairs are in place. The time must be used to good effect. Without those good measures, the world’s financial authorities might indeed have a far rougher time righting a system that would founder if an unforeseen significant event were to occur, or even if the current upswing simply runs its course. It was in these terms that the BIS rallied it members to vigilance and action.
From here: risks from the further build-up of financial imbalances and debt
Even if a mild slowdown or a soft landing in the global economy do not materialise in the near- to medium-term, as the BIS wrote, downside risks could increase over the longer term. In particular, the combination of a non-inflationary expansion and low interest rates could well end up encouraging the further, gradual build-up of financial imbalances and debt accumulation more generally. If circumstances were to evolve in this way, the central bankers fear that this might create the conditions for a more costly contraction further down the road.
In addition to private sector debt accumulation, pro-cyclical fiscal policies, facilitated by current low borrowing costs, could likely lead to a further rise in public debt from today’s already historically high levels in much of the world. This would be especially and unfortunately true if, as evidence indicates, the financial expansion preceding that eventual severe slowdown by having flattered the fiscal accounts in preceding periods. Although they are supportive of growth in the short run, expansionary fiscal policies could force retrenchment in the future and further limit any room for policy manoeuvre in the event of a squeeze. Indeed, a growing body of research studies documents how higher leverage, in both the private and public sectors, can boost growth in the short run, but at the cost of lower growth on average, including deeper and prolonged recessions, in the future. Are we eating our white bread?
From a long-term perspective, the continuous accumulation of debt is worrying for at least two reasons. First, the higher the debt, the more sensitive the economy and financial valuations are to higher interest rates, reducing the level of interest rates an economy can bear. This, in turn, makes it more difficult to raise them, favouring further debt accumulation - a kind of "debt trap" that the BIS annual report reviews at some length – this is also a signal to readers of central bank policy review priorities. Second, higher debt - private and public - hampers the ability to use policies to address any downturn.
BIS concluding word of caution
This broad analysis of risks, financial and real, points to a clear message. While the global economy has made substantial progress post-crisis and near-term prospects are positive, the path ahead is a narrow one. The risks highlight the importance of taking advantage of the current upswing to implement the necessary measures to put the expansion on a stronger footing and to rebuild policy buffers. Such buffers are essential to regain the room necessary to deploy the tools required to tackle the next downturn, which will surely come at some point.
What does this mean for Thomas Murray’s clients? If the central bankers remain so concerned, as they should, about the levels of debt and credit quality, and the potential for a rapid turnaround in the form of falling asset prices and sudden liquidity contractions after several years of relatively favourable conditions, then it is prudent for others to remain watchful. Central bankers are charged with being vigilant. So, one hopes, are the risk officers at infrastructure institutions and custody banks across the globe as regards asset quality and liquidity.
The author, Thomas Krantz, is Senior Advisor, Capital markets, in the firm of Thomas Murray; and served as Secretary General of the World Federation of Exchanges (2000-2012). The views expressed are his own, and not necessarily those of the firm.