The reliance of debt as an engine of global economic growth is not sustainable and boosting demand through further debt will only lead to financial fragility and increasingly disruptive financial cycles, according to the Bank for International Settlements (BIS).
In his speech to the annual meeting of the BIS, General Manager Jaime Caruana called on policy makers to take advantage of the current economic upswing to transition the global economy into a less debt-driven and thus more sustainable model, to move toward more normal monetary policy and a more reliable financial system.
Speaking to central bank governors gathered at BIS’ headquarters in Basel, Switzerland, Caruana said the 2007-2009 financial crises still casts a long shadow on the world economy although the healing has begun as reforms take hold, growth broadens in advanced economies, the euro area emerges from recession and the slowdown eases emerging market economies.
But the economic upswing is weak by historical standards as consumers, firms and banks continue to pay down debt and countries struggle to shift resources into productive sectors after the misallocation during the financial boom.
The heavy reliance on debt in recent decades to fuel growth masked an erosion of a decline in labour productivity and the only answers to this are country-specific reforms to the supply side of economies that promote a more flexible and profitable use of resources and create confidence in employment and income prospects.
“It is hard to see how additional debt-driven demand can help,” Caruana told more than 60 central bank governors.
BIS is owned by 60 central banks around the world and its board currently comprises the governors of the U.S. Federal Reserve, the Bank of Japan, the European Central Bank, the Bank of England and others.
“Ever-rising public debt cannot shore up confidence. Nor can a prolonged extension of ultra-low interest rates. Low rates can certainly increase risk-taking, but it is not evident that this will turn into productive investment,” Caruana said.
Since 2007, debt-to-Gross Domestic Product in the world’s 20 major economies has risen by more than one-fifth, partly due to massive stimulus to help overcome what the BIS now describes as the “Great Recession,” to reflect the fact that many emerging markets escaped relatively unscathed from the 2007-2009 crises.
Although advanced economies are starting to reduce fiscal deficits, overall debt-to-GDP ratios continues to grow and is now at 275 percent in advanced economies and 175 percent in emerging market economies.
“As debt increases, the ability of borrowers to repay becomes progressively more sensitive to drops in income and to interest rate rises. Thus, higher debt translates into greater financial fragility and financial cycles that may become increasingly disruptive,” Caruana said.
Continued ultra-low interest rates can have the effect of entrenching an economic balance that relies on high debt, low rates and anaemic growth, with a threat to financial stability as low rates promote further debt accumulation and risk taking.
Among the challenges that central banks, such as the Fed and the BOE, face in unwinding years of extraordinary accommodation, is making financial markets less dependent on monetary policy.
The decline in financial market volatility in the past few months is hardly a consequence of receding global risks but a reflection of investors becoming convinced that monetary conditions will remain easy for a long time.
“Such overconfidence is dangerous,” said Caruana, as it encourages excessive risk taking and may add to pressure on central banks to postpone rate increases.
Another challenge is the international spillovers of monetary policy.
Many emerging market economies have struggled with the knock-on effects of last year’s global sell-off in bond markets and the recent shift from bank to market-based finance may affect financial stability during the normalization of monetary policy.
“We have yet to learn whether a market-driven boom is more or less risk than a bank-driven boom,” Caruana said.
Hyun Song Shin, who joined the BIS as economic adviser and head of research in May, has described this phenomenon as the “second phase of global liquidity.”
“Taking account of monetary policy spillovers is a shared responsibility,” said Caruana, adding that “advanced economies need to better understand the international transmission and feedback of very accommodative monetary conditions and internalize this in their decisions.”