BIS - 84th Annual Report

84th Annual Report | 1 April 2013–31 March 2014
Basel, 29 June 2014

I. In search of a new compass

The global economy has shown encouraging signs over the past year. But its
malaise persists, as the legacy of the Great Financial Crisis and the forces that led
up to it remain unresolved. To overcome that legacy, policy needs to go beyond its
traditional focus on the business cycle. It also needs to address the longer-term
build-up and run-off of macroeconomic risks that characterise the financial cycle
and to shift away from debt as the main engine of growth. Restoring sustainable
growth will require targeted policies in all major economies, whether or not they
were hit by the crisis. Countries that were most affected need to complete the
process of repairing balance sheets and implementing structural reforms. The
current upturn in the global economy provides a precious window of opportunity
that should not be wasted. In a number of economies that escaped the worst effects
of the financial crisis, growth has been spurred by strong financial booms. Policy in
those economies needs to put more emphasis on curbing the booms and building
the strength to cope with a possible bust, and there, too, it cannot afford to put
structural reforms on the back burner. Looking further ahead, dampening the
extremes of the financial cycle calls for improvements in policy frameworks – fiscal,
monetary and prudential – to ensure a more symmetrical response across booms
and busts. Otherwise, the risk is that instability will entrench itself in the global
economy and room for policy manoeuvre will run out.

II. Global financial markets under the spell of monetary policy

Financial markets have been acutely sensitive to monetary policy, both actual
and anticipated. Throughout the year, accommodative monetary conditions kept
volatility low and fostered a search for yield. High valuations on equities, narrow
credit spreads, low volatility and abundant corporate bond issuance all signalled a
strong appetite for risk on the part of investors. At times during the past year,
emerging market economies proved vulnerable to shifting global conditions; those
economies with stronger fundamentals fared better, but they were not completely
insulated from bouts of market turbulence. By mid-2014, investors again exhibited
strong risk-taking in their search for yield: most emerging market economies
stabilised, global equity markets reached new highs and credit spreads continued to
narrow. Overall, it is hard to avoid the sense of a puzzling disconnect between the
markets’ buoyancy and underlying economic developments globally.

III. Growth and inflation: drivers and prospects

World economic growth has picked up, with advanced economies providing most of
the uplift, while global inflation has remained subdued. Despite the current upswing,
growth in advanced economies remains below pre-crisis averages. The slow growth
in advanced economies is no surprise: the bust after a prolonged financial boom
typically coincides with a balance sheet recession, the recovery from which is much
weaker than in a normal business cycle. That weakness reflects a number of factors:
supply side distortions and resource misallocations, large debt and capital stock
overhangs, damage to the financial sector and limited policy room for manoeuvre.
Investment in advanced economies in relation to output is being held down mostly
by the correction of previous financial excesses and long-run structural forces.
Meanwhile, growth in emerging market economies, which has generally been strong
since the crisis, faces headwinds. The current weakness of inflation in advanced
economies reflects not only slow domestic growth and a low utilisation of domestic
resources, but also the influence of global factors. Over the longer term, raising
productivity holds the key to more robust and sustainable growth.

IV. Debt and the financial cycle: domestic and global

Financial cycles encapsulate the self-reinforcing interactions between perceptions
of value and risk, risk-taking and financing constraints, which translate into financial
booms and busts. Financial cycles tend to last longer than traditional business
cycles. Countries are currently at very different stages of the financial cycle. In the
economies most affected by the 2007–09 financial crisis, households and firms have
begun to reduce their debt relative to income, but the ratio remains high in many
cases. In contrast, a number of the economies less affected by the crisis find
themselves in the late stages of strong financial booms, making them vulnerable to
a balance sheet recession and, in some cases, serious financial distress. At the same
time, the growth of new funding sources has changed the character of risks. In this
second phase of global liquidity, corporations in emerging market economies are
raising much of their funding from international markets and thus are facing the
risk that their funding may evaporate at the first sign of trouble. More generally,
countries could at some point find themselves in a debt trap: seeking to stimulate
the economy through low interest rates encourages even more debt, ultimately
adding to the problem it is meant to solve.

V. Monetary policy struggles to normalise

Monetary policy has remained very accommodative while facing a number of
tough challenges. First, in the major advanced economies, central banks struggled
with an unusually sluggish recovery and signs of diminished monetary policy
effectiveness. Second, emerging market economies and small open advanced
economies contended with bouts of market turbulence and with monetary policy
spillovers from the major advanced economies. National authorities in the latter
have further scope to take into account the external effects of their actions and the
corresponding feedback on their own jurisdictions. Third, a number of central banks
struggled with how best to address unexpected disinflation. The policy response
needs to carefully consider the nature and persistence of the forces at work as well
as policy’s diminished effectiveness and side effects. Finally, looking forward, the
issue of how best to calibrate the timing and pace of policy normalisation looms
large. Navigating the transition is likely to be complex and bumpy, regardless of
communication efforts. And the risk of normalising too late and too gradually
should not be underestimated.

VI. The financial system at a crossroads

The financial sector has gained some strength since the crisis. Banks have rebuilt
capital (mainly through retained earnings) and many have shifted their business
models towards traditional banking. However, despite an improvement in aggregate
profitability, many banks face lingering balance sheet weaknesses from direct
exposure to overindebted borrowers, the drag of debt overhang on economic
recovery and the risk of a slowdown in those countries that are at late stages
of financial booms. In the current financial landscape, market-based financial
intermediation has expanded, notably because banks face a higher cost of funding
than some of their corporate clients. In particular, asset management companies
have grown rapidly over the past few years and are now a major source of credit.
Their larger role, together with high size concentration in the sector, may influence
market dynamics and hence the cost and availability of funding for firms and
households.