Over the past year, the global economy has continued to improve. In emerging markets, growth has been strong, and advanced economies have been moving towards a self-sustaining recovery. But it would be a mistake for policymakers to relax. From our vantage point, numerous legacies and lessons of the financial crisis require attention. In many advanced economies, high debt levels still burden households as well as financial and non-financial institutions, and the consolidation of fiscal accounts has barely started. International financial imbalances are re-emerging. Highly accommodative monetary policies are fast becoming a threat to price stability. Financial reforms have yet to be completed and fully implemented. And the data frameworks that should serve as an early warning system for financial stress remain underdeveloped. These are the challenges we examine in this year's Annual Report.
Interrelated imbalances made pre-crisis growth in several advanced countries unsustainable. Rapidly increasing debt and asset prices resulted in bloated housing and financial sectors. The boom also masked serious longterm fiscal vulnerabilities that, if left unchecked, could trigger the next crisis. We should make no mistake here: the market turbulence surrounding the fiscal crises in Greece, Ireland and Portugal would pale beside the devastation that would follow a loss of investor confidence in the sovereign debt of a major economy.
Addressing overindebtedness, private as well as public, is the key to building a solid foundation for high, balanced real growth and a stable financial system. That means both driving up private saving and taking substantial action now to reduce deficits in the countries that were at the core of the crisis.
The lessons of the crisis apply to emerging market economies, too. And those where debt is fuelling huge gains in property prices and consumption are running the risk of building up the imbalances that now plague the advanced economies.
Global current account imbalances are still with us, bringing the prospect of disorderly exchange rate adjustments and protectionism. But the imbalances extend beyond current accounts to gross financial flows, which today dwarf the net movements commonly associated with the current account. And they pose perhaps even bigger risks by giving rise to potential financial mismatches and facilitating the transmission of shocks across borders. Not only that, but cross-border financing makes rapid credit growth possible even in the absence of domestic financing. As the experience of the past few years reminded us, a reversal of strong cross-border capital flows can inflict damage on financial systems and ultimately on the real economy.
The imbalances in current accounts and in gross financial flows are related and need to be addressed together. Sound macroeconomic policies will play a key role in this regard, as will structural domestic policies to encourage saving in deficit countries and encourage consumption in surplus countries. Although the adjustment of real exchange rates is also required, it will not, by itself, be enough. Countries will need to implement policies that strengthen prudential frameworks and the financial infrastructure. Capital controls, best left as a last resort, can offer only temporary relief.
While adjustment by surplus and deficit countries is necessary and mutually beneficial, it is constrained by a fundamental problem: countries may find unilateral adjustment too costly. This means that international coordination is essential to break the policy gridlock.
Turning to monetary policy, the challenges are intensifying even as central banks extend the already prolonged period of accommodation. The persistence of very low interest rates in major advanced economies delays the necessary balance sheet adjustments of households and financial institutions. And it is magnifying the risk that the distortions that arose ahead of the crisis will return. If we are to build a stable future, our attempts to cushion the blow from the last crisis must not sow the seeds of the next one.
Overall, inflation risks have been driven up by the combination of dwindling economic slack and increases in the prices of food, energy and other commodities. The spread of inflation dangers from major emerging market economies to the advanced economies bolsters the conclusion that policy rates should rise globally. At the same time, some countries must weigh the need to tighten with vulnerabilities linked to still-distorted balance sheets and lingering financial sector fragility. But once central banks start lifting rates, they may need to do so more quickly than in past tightening episodes.
With the end of unconventional policy actions in sight, central banks face the risks associated with the resulting large size and complexity of their own balance sheets. Failure to manage those risks could weaken their hard-won credibility in delivering low inflation, as could a late move to tighten policy through conventional channels.
Progress on financial regulatory reform has been impressive. International agreements on stronger capital requirements and new liquidity standards for banks have been reached quickly. Still, a number of critical steps remain. Among these are the full and timely implementation of Basel III; the adoption of measures to address the systemic risks associated with very large global financial institutions; and the design of regimes to ensure the orderly resolution of such institutions in the event of their failure. But the target will keep moving as institutions resume risk-taking and adapt their business models to the new environment. The supervisory framework must be able to keep up, monitoring and managing risks to financial stability regardless of the given perimeter of regulation.
The recent financial crisis revealed gaps in both the data and the analytical frameworks used to assess systemic risk. These gaps hampered policymakers in their efforts to identify and respond to vulnerabilities. To do their job, authorities need a broader and more accurate view of the financial system from multiple vantage points. That picture would show sectoral balance sheets and their global interlinkages, and it implies a wider sharing of institution-level data within and across jurisdictions. While better data and analytical frameworks will not prevent future crises, experience suggests that the improvements will enable policymakers and market participants alike to identify vulnerabilities previously unseen and pick up the emergence of others much sooner.