BIS-Stimulus plans might fail, lead to long stagnation

BASEL, Switzerland, June 29 Mon Jun 29, 2009 6:00am EDT

BASEL, Switzerland, June 29 (Reuters) - Bids to stimulate growth may spark only a temporary pick-up and then a long stagnation because banks are not being pushed hard enough to fix their underlying problems, the Bank for International Settlements (BIS) said on Monday.

In its annual report, the BIS -- which acts as a forum for the world's central banks -- said although authorities had tried to arrest sharp declines in economic output, it was still an open question whether the stimulus would lead to a sustained recovery.

"A major cause for concern is the limited progress in addressing the underlying problems in the financial sector," the BIS said.

As the financial crisis has deepened, central banks around the world have slashed interest rates and poured extra liquidity into markets, some by buying assets directly. [ID:nN22505328]

Governments have rushed to the aid of banks and pledged extra public spending worth about 2 percent of economic output at Group of 20 level this year, according to the International Monetary Fund. [ID:nLT60041]

But the BIS said governments may not have acted quickly enough to remove problem assets from the balance sheets of key banks, instead focussing on guarantees and capital -- also exposing taxpayers to potentially large losses.

Past experience showed that the key to recovery was to force the banking system to take losses, dispose of non-performing assets, eliminate excess capacity and build their capital base.

"These conditions are not being met. A significant risk is therefore that the current stimulus will lead only to a temporary pickup in growth, followed by protracted stagnation," the BIS said.

"The lack of progress threatens to prolong the crisis and delay the recovery because a dysfunctional financial system reduces the ability of monetary and fiscal actions to stimulate the economy."

The BIS, which has long warned of the dangers of asset price rises, said the crisis also showed central banks must take a more activist stance on asset and credit booms, leaning against the wind rather than mopping up the damage afterwards.

"The financial crisis has shown that it is ultimately too costly for central bankers to focus narrowly on inflation," it said, noting that this preoccupation may have led some to make policy mistakes.

"With the benefit of hindsight, one can see that policymakers underappreciated the extent of the slowdown in mid-2008 and the strength of the associated disinflationary forces," the BIS said.

EXIT NEEDED

A major issue for the future was how to negotiate an exit from the very expansionary policies now in place.

Increased public debt would weigh on budgets for years, possibly pushing up real interest rates and crowding out private investment, as well as undermining central bank asset buys. "Getting public finances in order will therefore be the main task of policymakers for years to come," the BIS said.

But the biggest risk was from a forced exit if markets lost faith in governments' ability to repay debt, while pressure on currencies might force central banks to run too-tight policy, especially in small and open economies.

Tightening policy too early could thwart the recovery but tightening too late might push up inflation, the BIS said, noting that both central banks and governments were likely to face strong political pressure to delay their exits.

"The short-term outlook is highly uncertain," the BIS said, noting most forecasters saw a global economic contraction of 1-2 percent this year, with growth to recover in 2010 but remaining well below trend.

"In the industrial countries, there are some signs that the rapid pace of decline in spending witnessed since the fourth quarter of 2008 has started to ease."

However, rising savings rates in industrialised nations could also derail the recovery. "There is a risk that the unusually synchronised downturn, combined with a possible jump in household saving, could well aggravate disinflation pressures over the next year or so," the BIS said.

Longer-term inflation expectations had remained stable, providing some reassurance against deflation, but these could also rise if consumers saw higher inflation as the only way to erode the build-up of public debt. Economic shakiness was not helped by a rise in currencies for Japan and the euro zone, while the UK was benefitting from a weaker pound. The rise of the U.S. dollar meant the exchange rate had become more neutral in trade dynamics over the past year.

(Editing by Ruth Pitchford)