10:15 AM Jun 9, 1997

INADEQUATE KNOWLEDGE, SAME POLICY ADVICE

Geneva, 9 June (Chakravarthi Raghavan) -- A scenario of paradoxes of global economic and financial developments in 1996 -- capable of plausible explanations, but nevertheless surprising -- have been brought out in the annual report of the Basle-based Bank of International Settlements (BIS).

The explanations don't add up, a view that the authors of the report hint at, but have not said in so many words.

BIS notes that over 1996, equity markets rose sharply in many countries - often in the face of stagnant levels of economic activity and low levels of inflation. European bond yield differentials narrowed as US bond rates increased, in contrast to what happened in 1994 and 1995.

The dollar rose in tandem with continued strength of the US economy - and persistent and growing trade deficits. In Japan and continental Europe investment spending failed to strengthen in the wake of rising exports. In parts of Latin America and Africa, prospects for sustained growth took a turn for the better, while in Asia imbalances became more evident.

And private capital flows to emerging markets exceeded previous records by wide margin, with capital flowing in (via bond markets) at declining risk spreads and investors in international security markets, accepting narrower margins, willing to take greater risks and making loans to previously unknown borrowers, with extended durations and experimenting with new currencies and ever more complex instruments.

"One part of an honest answer (to these developments) is that we simply do not know," say the BIS economists. "The ability to explain and predict must also be constrained by the limits of our knowledge. There are many economic processes (at work) that we do not fully understand, particularly in the financial area...

"Yet there is one thing we do know. Inflation, excessive monetary expansion and fiscal laxity contribute to misconceptions and bad judgement in a variety of forms..."

But in the absence of knowledge about the processes at work, the BIS authors fall back on advice for continuance of same policies as before: give central banks greater independence (but make them more accountable publicly) and ask them to aim for domestic price stability, ensure greater labour market flexibility and continued liberalisation of trade and investments, and things will work out (in the long-run).

Is the advice to continue with the same policies like strategies of Generals who always seem to be fighting the last war?

Or like physicians before the second world war (and the better diagnostics and miracle drugs that came up) who often could not distinguish between typhoid and pleurisy (where in both cases at initial stages patients have high temperatures in the morning and evening), and starved pleurisy patients, worsening their disease?

In the face of the admittedly "generally more powerful than expected" disinflationary forces in the world economy, particularly in the G-7 countries, would the world economy coast along at a slower rate or will lack of demand in the face of excess supply in the global economy (specially in the financial economy, but much less in real economy) catch these economists and policy-makers by surprise, and others will have to pay the penalty and costs?

French voters have made clear that they are not ready to pay the price demanded by present policies. And if Socialist Prime Minister Lionel Jospin and his left allies fail (as the neoliberals think or hope), just as between the two wars in Europe, the public might turn back to the Chirac and the right but, more easily to La Pen. In the interwar years in Europe, the people turned to fascism, which initially came to power by the ballot box.

The BIS report does not address these issues of political economy.

It cautions in particular against sudden and radical shift of policy, as seen in the past in Latin America, in the direction of encouraging external balance through currency depreciation.

It notes that while liberalisation of financial markets, and financial deregulation, has contributed to faster economic growth, liberalised financial sectors are also more prone to costly misadventures.

In a large number of industrial and emerging market economies, tax-payers in recent years have paid out a significant share of GDP to support and recapitalize failed banking systems. All too frequently, the subsequent macroeconomic effects in terms of lost output and rising unemployment have been considerably more costly.

"While we have not yet experienced the economic losses that might be associated with a major failure in payment systems, which now routinely process several trillion dollars worth of payments a day, a few close calls in recent decades were wake-up calls as well."

The BIS also cautions on prospective problems arising from "sharp increases in global competition in a world which is already over-banked and where rents from established franchises are being threatened by new technology."

Referring to electronic trading's effect in reducing margins on foreign exchanges, and an increasing number of firms having ability to compete in the "plain vanilla" end of the derivatives market, as also pressures for adjustment caused by financial deregulation and international competition between different financial institutions, BIS says "adjustment is not a bad thing... provided it is orderly"

For such orderly adjustment, firms must be able to respond to competitive pressures by increasing efficiency, even if it means reduction of employment; capital without inadequate return must be allowed to withdraw, and firms allowed to merge, even with foreign partners.

But in industrial and in emerging economies, these preconditions are not always fulfilled and the resulting danger is for the whole financial system to weaken, and firms under pressure increasingly inclined to take more risk in a "gamble for resurrection".

The answer to these problems is to ensure better governance of individual financial institutions, and strengthening of market infrastructures, particularly in emerging economies, to lessen dangers of contagion spreading across markets and countries.

Monies and jobs of owners and managers must be self-evidently at stake. The incentives to monitor yields on invested capital closely,and withdraw capital if yields are not commensurate with perceived risk, mount each time a financial firm is allowed to fail.

From the systemic perspective, not all failures are bad, it says.

Most of the well-publicised trading losses of recent years had accumulated undetected over a long period and some internal risk management system remain deficient in important respects, particularly when business is being conducted in geographically distant centres.

The incentive systems for traders and other bankers encourage inappropriate behaviour if gains (in profits or volumes) are rewarded, but losses are borne by the firm as a whole.

BIS also underlines the need for market disciplines, which require not only good accounting but enhanced disclosure requirements. The guidelines formulated for the derivatives markets, and the plans for finalisation in September of the Core Principles for Effective Banking Supervision are steps in this direction.

Rating agencies could also help in helping markets enforce standards established by supervisory authorities or self-regulatory bodies in the industry.

But BIS is silent on the more recent question that has arisen: who will rate the rating agencies?

It notes that in the industrial world, the role of the state is now having to be reassessed in the light of a sound money standard and revealed limits to government borrowing. In the BIS view, the exigencies of Maastricht criteria (and EU states trying to converge) must be judged to have played only a secondary role, though an important one in timing.

"More fundamentally, many governments in industrial countries began to question seriously whether they could still maintain all the regulations and honour all the promises made earlier to protect workers, pensioners and other beneficiaries of the social safety net. And the resulting uncertainties on the part of both consumers and investors are stretching out this process of fiscal consolidation by holding back spending, reducing tax revenues and thus further increasing the need for fiscal restraint to meet deficit dangers"

But whatever the reasons behind behaviour of financial market participants, BIS notes that 1996 saw a "determined effort on their part to reconstitute yields by taking on higher levels of both credit risk and market risk..."

On the economic front, there were conflicting policy signals.

The average levels of inflation fell further in the industrial countries, and inflationary pressures were less evident than could have been expected in the US and other countries where capacity limits were being tested.

There were also "policy puzzles" in Europe - with structural and macroeconomic components: weak demand was exacerbated by need for fiscal restraint and uncertainties relating to economic and monetary union; export orders were relatively buoyant, but investment spending failed to respond; and European economies were being subject to supply-side shocks while industrial restructuring gathered pace (in response to globalisation and technological change) - contributing to a further rise in unemployment in France and Germany.

In Asia, the substantial strengthening of the US dollar was an important aspect of policy conflicts: the effect of the lower yen on Japanese exports, supported output growth, but also brought to a halt previous decline in the Japanese current account surplus.

But BIS notes that the main counter-part of the US deficit is in the surplus of Western Europe which stood at more than $100 billion.

While US current account deficit rose almost to the record level of 1987, and slightly larger than the deficit of 1995, it was accounted by the continued surge in imports and a widening trade deficit.

With the US economy at virtually full capacity in 1996, stronger demand for US exports could not have been met without rising domestic inflation or macro-restraint. As a result, the deteriorating external position seems to have been high rate of domestic absorption.

Elsewhere in Asia, the effective value of many currencies have risen with the dollar and continuing capital flows: competitiveness has suffered at the same time as both volume and prices of exports of electronic goods have fallen sharply.

The potential for conflict between internal and external balance is relatively new for many Asian countries, particularly those that have relied on exports as the principal engine of growth. But the problem has been endemic in Latin America where policies directed at reducing inflation in 1990s often relied on use of exchange rates as a nominal anchor - implying a market real exchange rate appreciation as domestic inflation responded only with a lag. This has adverse implications for external balance, exposing countries to a potential lack of confidence, at home and abroad. A similar dilemma is also confronting a number of countries of East Europe.

An unusual feature of the continued expansion of the US economy has been its dependence on increased output of the "high-tech" sector which is estimated to have contributed 25% to overall growth over the last three years -- compared to 4% for the automobile sector.

But being highly dependent on continuous development of new technologies, the high-tech sector is not immune to cyclical swings or to accumulation of imbalances. As past experience has shown, output changes in this sector are as volatile as in most durable goods industries and can be accompanied by even larger multiplier effects on the rest of the economy, the BIS points out.

As for macroeconomic policies and developments in the industrial countries, BIS sees a clear need to reduce structural deficits over the medium term, given the ageing of populations and the growing burden of unfunded pensions and other social benefit schemes.

"The obvious risk in further tightening, particularly if conducted simultaneously by many countries, would be a slowdown of demand and a further widening of actual as opposed to structural deficits.

"..policies to reduce structural unemployment by removing various obstacles to firms' increasing their demand for labour could play an important role to fiscal restraint. If unemployed workers on state-financed benefits find jobs and spend more, the fiscal framework would gain in obvious ways. The associated increase in output potential would allow less demand restraint without posing a risk to maintaining low inflation. Such a combination of structural and fiscal reform should be given a particularly high priority in Europe where structural unemployment now exceeds 9% of the labour force, and the introduction of a single currency will remove a potential channel of adjustment to economic shocks."

But when the workers, in Europe and elsewhere, face prospects of reduced welfare state, will the unemployed returning to work get back to consumer binge (and thus stimulate the economy), or would they be more cautious and save? Answers have not at all been clear in Europe or the US.

The American and British examples of increased labour market flexibility (by curtailing power of trade unions and decentralising the wage bargaining process) resulting in less unemployment and resumption of growth is held out as example for other Europeans to follow.

But BIS notes that while in the UK, there has been a faster reduction in unemployment and rise in real earnings per hour, the UK fall in unemployment "seems to have been entirely the result of a growing proportion of 'non-active' persons -- i.e. those that either leave or don't join the labour force."

"Employment measured as a share of total population, has been stagnant," says BIS, and adds that a more equal regional distribution of unemployment has probably helped to contain wage pressures.

Unemployment in the UK has also been reduced by continuing rise in proportion of part-time workers. But part-time work is less suitable in industry than in services.

As for trade/FDI/employment issues, BIS says that though there is some evidence that growing trade with emerging markets have had adverse effects on unskilled workers in some sectors (notably textiles, clothing and footwear), the general consensus among economists is that overall impact both on employment and relative wages has been small.

This is because while imports from emerging market countries have grown rapidly, they still account for a small share of total output of industrial countries and relative wages are still determined by national factors than of world market. Also, while emerging markets have increased their exports, they have also increased their imports. And most unskilled and skilled workers are found in wholesale or retail trade sectors which so far have been little exposed to international competition.

In Europe the high domestic costs of labour have encouraged FDI outflows and job growths abroad and reduced demand for labour in the parent countries -- as in Switzerland, Sweden and Germany.

However, says BIS, concerns based on these observations could be overstated.

The bulk of FDI flows is among the industrial countries, and motivated by factors other than labour costs. A large segment of FDI flows is also to the services sector, frequently to facilitate sale and distribution of exports from home country.

The regional pattern of FDI stocks have also remained remarkable stable over time. Though emerging markets in Latin America and Asia, as well as in Eastern Europe, receive a rising share of investment outflows, a dominant part still is of FDI among industrial countries, and particularly EU countries. And because of the long slump in FDI outflows to emerging markets in the 1980s, specially to Latin America, the distribution of FDI stocks is even more dominated by investment in industrial countries -- 24.6% in North America, 40% in Europe and only 17.8 in Latin America and Asia.

And US FDI has mostly been undertaken to serve local or third markets - with exception of FDI to Canada and Mexico where inter-industry and intra-firm links have led to complementarities in production structures and significant sales back to the US.

Overall, Japanese affiliates sell an even higher share in local and third markets; but since 1990 the proportion of FDI outflows from Japan to Asia has grown from 10 to 23 percent and Japanese affiliates are increasingly exporting back to Japan - and this has already begun to affect Japan's foreign trade in manufactures.

On the economic scene elsewhere in the world, BIS notes that economic growth remained buoyant and inflation fell further in emerging economies. Average growth in Latin America rose on the strength of recovery in Argentina and Mexico, while stabilization and reform policies in Africa promoted fastest growth in two decades.

But in several Asian countries, policies shifted to restraint, and weak export markets contributed to moderation of growth. In a number of east European countries, more advanced in the transition process, solid growth was maintained, but output in russia is yet to be firmly established.

As in industrial countries, financial globalisation and liberalisation has transformed the tasks of pursuing both internal and external balance in the emerging economies. In the current environment of high capital mobility, pursuing separate monetary and exchange rate policies has become more problematic. Conflicts between internal and external objectives have been more pronounced in some countries.

In several Latin American countries, tight monetary policies and/or fixed exchange rates led to significant reductions in inflation in the 1990s, but at the price of real exchange rate appreciation and widening current account deficits.

But several Asian countries were able to maintained competitive exchange rates without unduly fuelling inflation. But more recently, overheating in much of the region has called for greater monetary restraint and real appreciation has emerged. It remains to be seen whether Eastern European countries will succeed in reducing inflation further without sacrificing external balance.

On the monetary policy front, BIS notes that the environment in industrial countries was marked by low inflation and sharp increases in prices of financial assets. Price advances in some equity markets, it cautions, could contain an unsustainable element, giving rise to concern that a fall in asset values may influence economic conditions negatively.

While the BIS has used some cautionary language about the price advances on financial assets, a spate of recent writings have raised some warnings about a 'bubble economy'.

Some writers have noted that in 1987, the dow-jones index stood at 2700, and after the meltdown came to 1700, but soon rising again now to stand at over 6000, and ask the question: has the value of productive assets of the companies used in the index and the price/earnings ratio grown ten-fold in the decade? If not, what is in store, particularly in the face of all indicators of a growing surplus capacity worldwide and a stagnant demand?

BIS notes that while most discussions on over-valuation of assets have focused on equity markets, bond markets too warrant attention.

"The strong convergence of bond yields in Europe, and sharp declines in rates in the historically high-yielding markets, suggest that part of the explanation for the recent gains in asset values may be an increased appetite for risk which might easily be reversed."

Comparing the asset valuations and the price-earnings multiples, BIS notes that in September 1987, the price/earnings ratio for the US market was not exceptionally high. Yet, US equities lost about 30% of their value in the subsequent global market correction. In March 1997, price/earnings multiples in Germany, France, Belgium and Netherlands exceeded those of September 1987, when each of these countries were at a point of the business cycle similar to that reached recently.

Whether recent gains in equity prices could prove sustainable will depend on future course of corporate profits. Analysts are forecasting earnings growth in the US of 13% a year on average over the next three to five years. Since the closing of the output gap in the US in 1994, earnings growth has been far in excess of such previous closures.

Aggressive corporate cost-cutting, increased rate of technological advance and opening up of new markets are given as reasons to explain the earnings growth and justify its expected continuation.

But the sustainability of these equity prices would depend on how far the appreciation of the US dollar would prove to be temporary. Also, a further increase in long-term interest rates outside the US or reduced willingness of market participants to take on risks would put a downward pressure on share prices. And so would many significant tightening of US monetary policy.