BASEL: The global economy might be set for an unexpectedly severe downturn, the world’s top central banking forum said yesterday, blaming lax credit for fueling the current financial crisis.
The Bank for International Settlements pinpointed “imprudent and excessive credit growth” as the root cause of the current crisis, in its latest report.
The bank, known as the central bankers’ central bank, suggested that interest rates should tend toward vigilance even in good times in order to discourage excessive borrowing.
While it was difficult to predict the severity of a downturn, it appeared that a “deeper and more protracted global downturn than the consensus view seems to expect” was on the way, the BIS said.
It dampened hopes that emerging markets which have been booming, would offset the slowdown, saying that many of these markets were significantly dependent on external demand, notably from the world’s largest economy the US.
“With a significant risk of recession in the United States, compounded by sharply rising inflation in many countries, fears are building that the global economy might be at some kind of tipping point. These fears are not groundless,” said the BIS.
The global financial sector has been under pressure for a year, in a crisis during which banks and financial institutions reported sharp losses and massive asset writedowns.
For the BIS, the subprime mortgage market or credit given to borrowers with poor credit ratings, which was widely blamed for the crisis, was not a root cause of the turmoil, but a trigger.
The real culprit, it said, was simply lax credit. Years of cheap borrowing had led to an extraordinary accumulation of debt.
In the United States, the ratio of household savings to disposable income was about 7.5 percent in 1992. The ratio fell sharply in the early 2000s. By 2005, it had plunged to almost zero.
This differentiated the current financial turmoil from other crises, when governments or states going bankrupt was often the issue.
In other words, “in sharp contrast to recurrent sovereign debt crises, is that there are now millions of troubled borrowers, particularly US households, as well as a myriad of lenders”, said the BIS.
The BIS dissected the current crisis into six stages, with the first stage emerging around June last year when financial institutions began reporting massive losses on subprime mortgage instruments.
By stage two, or the mid to end July period, the crisis had spread to other credit markets. In August, banks were finding it difficult to borrow from each other.
Meanwhile between March to May, it came to a peak with the US Federal Reserve intervening to avert the collapse of major investment firm Bear Stearns.
But even while the worst may be over, the BIS said there remained great uncertainty on the severity of the impact on the economy.
One wildcard was inflation, which is at the moment extremely pronounced due to record energy and commodity prices.
The effect of the depreciating dollar was another challenge, as it could further stoke inflation, which in turn would lower consumers’ appetite on spending. “Against this background, while most commentators expect some slowing of global economic growth, there is an exceptional degree of uncertainty as to how severe the slowdown might be,” it said.
In the short-term, the BIS assessed that governments must move to reduce the possibilities of banks collapsing, by encouraging banks to cut dividends and bonuses in order to increase capital cushions. In addition, the private sector should be tapped for capital injections.
But in the long-term, it was the issue of cheap credit — which is at the heart of the crisis — that had to be addressed.
In a suggestion that appeared to go against the economic principle that when inflation is under control, central banks should keep rates low to spur economic growth, the BIS suggested that central banks keep interest rates on a vigilant stance even when inflation was not a threat.
“Monetary policy might be tightened even with projected inflation under control, given a sufficiently worrisome combination of rapid credit growth, rising asset prices and distorted spending or production patterns,” the BIS said.
