Tuesday, 25 June 2013
Soaring bond yields across the world threaten trillion of dollars in losses for investors and a fresh financial crisis.
The Swiss-based institution said losses on US Treasury securities alone will reach $1 trillion if average yields rise by 300 basis points, with even greater damage in a string of other countries. The loss could range from 15pc to 35pc of GDP in France, Italy, Japan, and the UK. “Such a big upward move can happen relatively fast,” said the BIS in its annual report, citing the 1994 bond crash.
“Someone must ultimately hold the interest rate risk. As foreign and domestic banks would be among those experiencing the losses, interest rate increases pose risks to the stability of the financial system if not executed with great care.”
The warning comes after US Federal Reserve set off the most dramatic spike in US borrowing costs for over a decade last week with talk of early exit from quantitative easing (QE), sending tremors through the global system.
The yield on 10-year Treasuries has jumped 80 basis points since the Fed began to talk tough two months ago, closing at 2.51pc on Friday.
The side-effect has been a run on emerging markets, a reversal of hot-money inflows into China, and fresh debt jitters in Portugal, Spain, and Italy. Nomura said the US yield spike threatens to “expose the cracks in Europe once again” and short-circuit the US housing recovery.
The BIS, the lair of central bankers, said authorities must press ahead with monetary tightening regardless of bond worries, warning that QE and zero rates are already doing more harm than good. The longer they go on, the greater the dangers.
“Central banks cannot do more without compounding the risks they have already created,” it said in what amounts to an full assault on the credibility of ultra-stimulus policies.
Describing monetary policy as “very accommodative globally” , it warned that the “cost-benefit balance is inexorably becoming less and less favourable.”
The BIS appeared call for combined monetary and fiscal tightening, prompting angry warnings from economists around the world that this risks a second leg of the crisis and perhaps a slide into depression.
“It is a resurgence of extreme 1930s liquidationism. If applied this would do grave damage to the world economy,” he said.
Marcus Nunes from the Fundação Getúlio Vargas in São Paulo said the report “reeks of Austrianism”, referring to the hard-line view of the Austrian School that debt busts lead to `creative destruction’ and should be allowed to run their course.
Prof Nunes fears a repeat of 1937 when premature tightening aborted recovery from the depression. “What is implicitly proposed is a degree of fiscal and monetary contraction that would make 1937 feel like a ‘walk in the park on a sunny day’.
The BIS said monetary stimulus has created a host of problems, including “aggressive risk-taking”, “the build-up of financial imbalances”, and further “misallocation of capital”.
It said the central bank mantra of doing “whatever it takes” to boost growth has outlived its usefulness, and has left the Fed, the Bank of England, and others, stuck with $10 trillion in bonds. “Central banks cannot repair the balance sheets of households and financial institutions. Central banks cannot ensure the sustainability of fiscal finances,” it said.
The emergencies policies have bought time for governments to put their budgets in order and tackle the deeper crisis of falling productivity, but this has been squandered. The BIS said leaders have put off the reforms needed to clear out dead wood and unleash fresh energy. Productivity growth in the rich states has dropped from 1.8pc between 1980-2000, to 1.3pc from 2001-2007, to just 0.7pc from 2010-2012. It has turned negative in Britain and Italy.
“Extending monetary stimulus is taking the pressure off those who need to act. In the end, only a forceful programme of repair and reform will return economies to strong and sustainable real growth,” it said.
Piling on the pressure, the BIS said to call for draconian fiscal tightening to avert a future debt crisis across the big industrial economies, with Britain needing to slash its `primary budget’ by up to 13pc of GDP to meet ageing costs.
“Public debt in most advanced economies has reached unprecedented levels in peacetime. Even worse, official debt statistics understate the true scale of fiscal problems. The belief that governments do not face a solvency constraint is a dangerous illusion. Bond investors can and do punish governments hard and fast.”
“Governments must redouble their efforts to ensure that their fiscal trajectories are sustainable. Growth will simply not be high enough on its own. Postponing the pain carries the risk of forcing consolidation under stress – which is the current situation in a number of countries in southern Europe.”
The call for double-barrelled fiscal and monetary contraction is remarkable, challenging the widely-held view that easy money is crucial to smooth the way for budget cuts and deep reform.
The BIS is in stark conflict with the International Monetary Fund and most Anglo-Saxon, French, and many Asian economists, as well as the team of premier Shinzo Abe in Japan. What is emerging is a bitter dispute over the thrust of global economic policy at a crucial moment.
Critics say the BIS is discrediting monetary remedies before it is clear whether the West is safely out of the woods. It may now be much harder to push through fresh QE if it turns out that the Fed has jumped the gun with talk of early bond tapering.
Scott Sumner from Bentley University said the BIS is wrong to argue that delaying exit from QE and zero rates is itself dangerous. The historical record from the US in 1937, Japan in 2000, and other cases, is that acting too soon can lead to a serious economic relapse. When the US did delay in 1951, the damage was minor and easily contained.
Prof Sumner warned that Europe risks following Japan into a deflationary slump if it takes the advice of the BIS and persists with its current contraction policies.