Saturday, July 1, 2017

BIS Annual Report - Undestanding Globalisation

The Bank for International Settlements (BIS) has issued their annual report with this report focusing on the argument that globalisation done properly raises overall living standards. The press release for the report can be viewed here.

The report is pretty tame and does not call for any kind of radical changes to present monetary policies or the monetary system. Below is the summary of the section of the report on Understanding Globalisation and then a couple of excerpts that illustrate that not much new in the way of change is called for.

We will use this part of the report in place of the usual monthly Crisis Watch update since there is not much new to report in terms of any signs of a looming financial crisis. The BIS report does mention some systemic risks as usual, but does not imply that any of them are of immediate concern. A possible shortage of US dollars abroad is one area that BIS says should be watched. 


Understanding globalisation

18 June 2017
Economic globalisation has contributed to a substantial rise in living standards and falling poverty over the past half-century. Tighter trade and financial integration are deeply intertwined: international trade not only relies on, but also generates, financial linkages. Together, international trade and finance have enhanced competition and spread technology, driving efficiency gains and aggregate productivity. Like any other form of far-reaching economic change, globalisation poses challenges. For example, globalisation has coincided with rising within-country income inequality in some countries, although the evidence indicates that technology has been the main driver. Moreover, financial openness exposes economies to destabilising external influences. Properly designed domestic policies can enhance the gains from globalisation and mitigate the adjustment costs. And international cooperation must supplement such policies in order to address global linkages. Completing international financial reforms is one priority. Global currencies call for international cooperation, effective crisis management and more systematic consideration of cross-border spillovers and spillbacks.

Past episodes of financial instability have demonstrated the importance of three international propagation mechanisms. First, highly mobile international capital can behave in a very procyclical manner, amplifying financial upswings and reversals. Second, foreign currency exposure, in particular in dollars, transmits tighter global financial conditions and exposes countries to foreign exchange losses. And third, close financial linkages between globally active financial institutions can spread financial stress, although they may also act as a buffer when problems have a domestic origin.
. . . . . .
This global currency channel is especially powerful in the case of the US dollar – the dominant international currency. The outstanding stock of US dollardenominated credit to non-bank borrowers outside the United States, a key indicator of global liquidity conditions, stood at $10.5 trillion as of end-2016. This outsize external role means that changes in the US monetary policy stance have a substantial influence on financial conditions elsewhere (Box VI.C). And since monetary policymakers, including those in control of major international currencies, are focused on domestic conditions, they could unintentionally end up contributing to financial imbalances well beyond their national borders. Notably, against the backdrop of the exceptionally accommodative US monetary policy stance, US dollar credit to non-bank EME borrowers roughly doubled between 2008 and 2016, reaching $3.6 trillion at the end of that period.
. . . . . .
The intermediation of global currencies, especially the dollar, also creates close linkages between globally active banks. The GFC demonstrated how such interconnectedness propagated funding stress between the world’s largest banks and forced them to deleverage internationally. Thus, the regulatory reforms in the aftermath of the GFC have focused on strengthening the resilience of international banks that are the backbone of global financial intermediation.
From the Conclusion:
The globalisation surge over the past half-century has brought many benefits to the world economy. Openness to trade has enhanced competition and spread technology, driving efficiency gains and aggregate productivity. The resulting stronger income growth has supported a remarkable decline in global poverty and cross-country income inequality. The ability to source cheaper, and better-quality, goods and services from all over the world has also directly increased households’ living standards. And the benefits do not just relate to trade. Financial openness is inextricably intertwined with trade openness: financial linkages both support trade, and are created by trade. Financial openness, properly managed, can also independently enhance living standards through a more efficient allocation of capital and know-how transfers.
While globalisation increases living standards, it does create challenges. First, the gains are not equally distributed. The distributional implications of trade and financial openness need to be addressed to ensure fair outcomes within societies and continued support for growth-enhancing policies and economic frameworks, including global commerce. That said, other factors – most notably technology – have played a dominant role in the increase in income inequality. Just as there is no suggestion to wind back technology, reversing globalisation would be greatly detrimental to living standards.
. . . . . .
As regards global financial institutions, the first priority is to complete the international financial reforms already under way. These reforms will go a long way to boosting the resilience of the global financial system. An agreed global regulatory framework is the basis for effective supervision of internationally active banks, including mechanisms for cross-border information-sharing. And it fosters a level playing field, a precondition for efficiency and soundness at the global level.
As regards global currencies, effective crisis management mechanisms remain important, and naturally require international cooperation. Central banks have built on the successful cooperation during the GFC. Among the central banks of major currency areas, foreign currency swap lines exist or could be established quickly as needed. And there may be some room to strengthen these mechanisms further, even though risk management and governance issues loom large. However, a greater emphasis on preventing the build-up of financial imbalances appears desirable. At a minimum, this would mean taking more systematic account of spillovers and spillbacks when setting policies.
International cooperation is also needed beyond finance to ensure a level playing field in trade and areas such as tax. Multilateral trade agreements provide the largest common markets to maximise efficiency. Trade and financial linkages enable companies, particularly large multinationals, to make decisions regarding production and profit declaration to minimise their taxes. Avoiding this can ensure that highly mobile capital can share the tax burden with less mobile labour, and so address income inequality. Together, such well designed domestic and international actions can ensure that globalisation continues to be a greatly beneficial force for the world economy and people’s living standards.
Added note: In terms of what we normally cover here related to the monthly Crisis Watch Update, we do have this rather ominous sounding article from the Indepenence (UK). They offer this quote from Claudio Borio of the BIS:

Claudio Borio, the head of the BIS monetary and economic department, said a new recession could come “with a vengeance” and “the end may come to resemble more closely a financial boom gone wrong”.

I would like to point out that articles like this one are one reason that it is very hard for those of us on the outside of the system to get a handle on the true prospects for a new major crisis. This article (at least to me) makes it sound as if BIS official Claudio Borio is forecasting a coming global crash. In reality, that is not the case and I did confirm that with highly credible sources. It is thought there may have been a misinterpretation of a quote that was released which was amended to try and clarify things (a comma was removed from the original comment, see more detail below).

The BIS does try to make people aware of systemic risks, but a careful reading of their most recent annual report does not imply that they see any kind of "global crash" on the near term horizon. 

I was asked to pay particular attention to these paragraphs in the report (on page 47) where the BIS explains the limitations of their early warning indicators related to risks they identify (added underline is mine):

"However, early warning indicators are subject to a number of caveats. On the one hand, they are not comprehensive: they omit other potential sources of financial distress, such as sovereign risk. On the other hand, they need to be interpreted with caution. First, by construction, they balance the risk of issuing false alarms with that of failing to identify future distress: false positives are inevitable. Second, although they can capture the general build-up of financial risks, they cannot identify precisely when the risks will materialise, let alone the intensity of potential strains. Third, their link with financial crisis risks can change over time. Importantly, many countries have developed and implemented macroprudential frameworks to improve financial sector resilience. And, in the wake of the GFC, major steps have been undertaken globally to enhance regulatory and supervisory frameworks more generally.

In addition, EMEs (Emerging Market Economies) have taken steps to reduce their vulnerability to large and abrupt exchange rate depreciations. They have adopted more flexible exchange rate regimes and accumulated large FX reserves (Graph III.5, right-hand panel). As a ratio to GDP, FX reserves have more than tripled since the mid-1990s, reflecting in particular developments in Asian EMEs. Moreover, EME private foreign asset holdings have risen, providing an additional potential line of defence.

On balance, the analysis suggests that financial cycle risks are material in a number of economies. Even if, owing to steps to strengthen financial system resilience, outright financial distress did not emerge, financial cycle downturns could weaken demand and growth, not least by dampening consumption and investment."
further explanation of the Claudio Borio quote mentioned above:

The original quote taken from Mr. Borio sounded like this (from the Telegraph version):

“The end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed, with a vengeance,” said Claudio Borio, the BIS’s chief economist.

As you can see, his remarks (scroll midway down) have now been amended to read like this:

"That end may come to resemble more closely a financial boom gone wrong, just as the latest recession showed with a vengeance. "

The comma after "just as the latest recession showed" was removed in an effort to clarify that Mr. Borio was talking about the 2008 GFC when he use the term "with a vengeance". He was not attempting to predict something new is about to happen "with a vengeance". This appears to just be an honest misinterpretation based on the original comments. However, the it is important to note the difference since one version tends to imply a prediction of a severe future major crisis while the other (correct version) is talking about the severity of the last crisis.

Problems with accuracy and also bias in media are really becoming a big problem in the highly politicized era we are living in now.  The pledge here is that I will try my best to vet articles before featuring them here. This is also why I am very careful to feature experts that I know and trust. We have tried very hard here to avoid any kind of agenda and to be as accurate as possible when presenting information. Reader input is always welcome and if you see an error, please feel free to let me know. 

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