BIS Annual Report 2016 - media briefing by Claudio Borio and Hyun Song Shin
On-the-record remarks by Mr Claudio Borio, Head of the Monetary and Economic Department, 22 June 2016
Events matter, but the rhetoric employed to describe them is also important. Take the expression "anaemic ongoing recovery", commonly used to describe the current state of the global economy. It suggests that the economy is still a long way from normal growth or unemployment rates, that there is a large cyclical shortfall to be filled, and that the immediate pre-crisis benchmark is the right one. In fact, global growth last year was not far away from historical averages - on a per working person basis, it was even slightly higher. Unemployment rates declined further and in many cases ended up close to historical norms. And, as empirical evidence tells us, output following financial crises may regain its previous long-term growth rate, but it is unrealistic to expect that it will return to its pre-crisis path. On that basis, the expression "anaemic ongoing recovery" hardly seems to do justice to how far the global economy has come since the crisis.
But this does not mean that the economy has achieved a robust, balanced and sustainable expansion. There are worrying developments, a sort of "risky trinity", that bear watching: productivity growth that is unusually low, casting a shadow over future improvements in living standards; global debt levels that are historically high, raising financial stability risks; and room for policy manoeuvre that is remarkably narrow, leaving the global economy highly exposed.
Hence a sense of discomfort, manifested most concretely in a further decline in interest rates, in nominal and inflation-adjusted terms, from already persistently and exceptionally low levels. Since last year, a few central banks have even pushed nominal policy rates into negative territory. And the amount of sovereign debt trading at negative yields has soared, from an already unprecedented $2 trillion to close to $9 trillion in mid-June 2016 - a new record. We continue to stretch the boundaries of the unthinkable.
By its very nature, the risky trinity has not appeared overnight. It has taken time to emerge and become entrenched. Productivity growth is slow-moving; debt accumulates gradually; and the narrow room for manoeuvre reflects a long series of incremental policy decisions. We are talking about years, if not decades.
That is why, as stressed in previous Annual Reports, understanding the evolution of the global economy requires a long-term perspective. In this perspective, financial factors loom large. The hypothesis we have explored, and taken further this year, is that the current predicament in no small measure reflects the failure to get to grips with hugely costly financial booms and busts ("financial cycles"). These have left long-lasting economic scars and complicated the return to normality.
This perspective helps us better understand the latest set of scenes in this long movie - a broad-based realignment that started in the period under review. Domestic financial cycles have been maturing or turning in a number of EMEs, not least China, where growth has slowed. Commodity prices have fallen, especially the price of oil. The US dollar has appreciated, in particular against EME currencies, as the Federal Reserve began to normalise policy while other major central banks eased further. And financing conditions have begun to tighten for those who had borrowed heavily in dollars in the rest of the world, as global liquidity has become less plentiful. Hyun will elaborate on this point.
These developments are not the result of unconnected bolts from the blue, but an inevitable and needed realignment driven by the underlying forces that have been shaping the global economy over many years, if not decades - in economic parlance, it is the "stocks" that matter, much more than the "shocks".
Here the role of debt is critical. Debt has been at the heart of the domestic financial cycles that have rotated since the crisis: while the private sector gradually deleveraged in crisis-hit advanced economies, it leveraged up with gusto elsewhere, especially in EMEs, in ways reminiscent of the financial booms that preceded the Great Financial Crisis. It was debt, from both domestic and foreign sources, that added fuel to the commodity boom and EMEs' expansion. And it was foreign currency debt, largely in US dollars, that surged outside the country as the Federal Reserve maintained its extraordinarily easy policy stance and the dollar depreciated. The realignment saw these processes partially reverse, although it has taken a breather since the financial market turbulence early in the year.
On this broad canvas, this year's Report zooms in to explore some specific themes.
First, it examines concerns about the fragility of market liquidity. Market liquidity will inevitably evaporate under severe stress. The best way to limit the risk of stress emerging and damaging the financial system is to strengthen financial intermediaries. Stronger market-makers mean more robust market liquidity.
Second, it reviews the latest steps to complete financial reform, with special emphasis on Basel III and its macroeconomic implications. Completing Basel III is critical to ensuring that the financial system is resilient during the realignment and beyond, and that it supports the economy. Well capitalised banks are the cornerstone of a well functioning economy. Stronger banks lend more.
Third, the Report devotes a whole chapter to exploring how fiscal policy could become an essential element of a macro-financial stability framework, designed to tackle financial booms and busts more systematically and promote stability more generally. This requires protecting the sovereign from financial system risks and the financial system from sovereign risk. It is an area that has not received the attention it deserves.
Finally, the Report further empirically examines the merits and main features of a financial stability-oriented monetary policy. It suggests that for monetary policy to yield the hoped-for benefits, it would need to take systematic account of the financial cycle, during both booms and busts, so as to keep the financial side of the economy on an even keel. This would complement its current focus on inflation. Monetary and financial stability are two sides of the same coin.
But what should be done now? There is an urgent need to rebalance policy in order to shift to a more robust, balanced and sustainable expansion. We need to abandon the debt-fuelled growth model that has brought us to this predicament. It is essential to relieve monetary policy, which has been overburdened for far too long. This means completing financial reforms, judiciously using the available fiscal space while ensuring long-term sustainability; and, above all, it means stepping up structural reforms. These measures should be embedded in efforts to implement an effective macro-financial stability framework better able to tackle the financial cycle. In all this, a firm long-term focus is paramount. We badly need policies that we will not once again regret when the future becomes today.
We are seeing a broad-based realignment of the global economy as the debt cycle has matured in emerging market economies (EMEs) and commodity and financial markets have been pulled to and fro by the ebb and flow of global liquidity. It is tempting to see these developments as separate "shocks", but they are outward manifestations of the same underlying cause - the maturing of the debt cycle in EMEs and the readjustment of global economic forces that is entailed by the turn of this cycle. To those who invoke "shocks" we say, "It's the stocks, not the shocks."
The global realignment has impacted on growth, especially in emerging economies, as well as on commodity prices. However, it has been most evident in the large adjustments of exchange rates, especially for emerging market currencies against the US dollar. These exchange rate adjustments are both a symptom of and a catalyst for the global realignment.
In the Annual Report, we discuss two faces of exchange rate adjustments, and how they are reflected in two channels of transmission to the real economy.
One is the traditional role of the exchange rate as an automatic stabiliser for the trade balance. Here, a depreciation of a country's currency, making its exports cheaper and imports more expensive, boosts GDP by increasing net exports.
However, there is a second, financial channel. The financial channel of exchange rates works in the opposite direction to the trade channel, and is reflected in the fluctuations in foreign currency-denominated debt. This has been an important channel of economic adjustment since the global financial crisis, and has been evident in the last 18 months or so as the build-up in foreign currency liabilities has begun to reverse. Here at the BIS, we have dubbed this second channel the "risk-taking channel of exchange rates".
In the build-up phase, an appreciation of the local currency strengthens the balance sheets of borrowers with foreign currency liabilities. Corporate investment buoys real activity, and the greater creditworthiness of the borrowers makes them a more popular destination of global investors' funds. Private sector debt therefore increases. These are also the times when commodity prices are high. Governments that are dependent on oil revenues find themselves with stronger fiscal positions and end up spending more. All these forces combine to make a currency appreciation expansionary.
However, as the cycle has turned, the forces that had combined to boost real activity in a virtuous circle have combined to dampen real activity in the downward phase. Ultimately, the length and cost of adjustment will depend on how large the stocks are, especially of the foreign currency-denominated liabilities chalked up by emerging market borrowers. Exchange rate adjustments are both a symptom of and a catalyst for this adjustment.
This year's Annual Report delves deeper into the two faces of exchange rates. It explores how the value of the dollar and cross-border bank lending in dollars are closely related. As a rule of thumb, a 1% depreciation of the dollar is associated with a 0.6 percentage point increase in the quarterly growth rate of US dollar-denominated cross-border lending. There are also implications for credit spreads for EME sovereigns. When an emerging market currency appreciates, the local currency sovereign yields fall. So, both in quantities and in terms of price, currency appreciation and looser financial conditions go hand in hand. In the downward phase, currency depreciation is associated with tighter financial conditions.
In more detailed analysis of how GDP growth depends on exchange rates (Chapter III, Box III.B), we find that the two faces of the exchange rate have opposite effects on GDP growth.
The first is the trade-weighted exchange rate, which reflects the trade channel. Here, an appreciation is contractionary, in the usual way.
However, the external debt-weighted exchange rate, which is the weighted average of the exchange rate to major currencies in proportion to external debt exposures, goes in the opposite direction to the trade channel. A currency appreciation boosts growth while a depreciation acts as a drag. Tellingly, this effect is only reliably present in emerging market economies. The effect on advanced economies is statistically insignificant.
It also turns out that the growth impact of currency appreciation in EMEs is larger in the short run than in the long run. This suggests that the economic boost that comes from the financial channel may have a strong short-term cyclical component which does not deliver enduring output gains. These observations are consistent with the boom and recent slowdown in growth in EMEs. It is another confirmation of the importance of focusing attention on stocks, not just the flows. To this extent, attempting to stimulate output by adding further to the overhang of the stock of debt makes future adjustment more challenging.
To sum up, as the saying goes: "It's the stocks, not the shocks." Addressing the overhang of foreign currency-denominated debt stocks would be one element of securing better macro outcomes in emerging market economies.