The global economy could be heading into an unexpectedly severe downturn, the top world central banking body warned on Monday, saying that cheap lending rather than the subprime drama was to blame. The Bank for International Settlements (BIS) pinpointed "imprudent and excessive credit growth," rather than the U.S. home-loan upheaval, as the root cause of the financial crisis which is now undermining growth.
The bank, known as the central bankers' central bank, suggested in implicit advice to its member central banks that they should tilt interest rates toward vigilance even when inflation was low to discourage excessive borrowing.
The report was published amid a raft of gloomy economic news in the form of record oil prices and eurozone inflation. And Ireland reported a 1.5% contraction of its formerly roaring economy.
The BIS said in its annual report that although forecasting the severity of a downturn was difficult, it appeared that a "deeper and more protracted global downturn than the consensus view seems to expect" was on the way. During a news conference, BIS general manager Malcolm Knight took the view that economies in Europe had done well while in Asia, "evidence still is that growth remains strong." But he warned that there were "quite significant downside risks to global growth," particularly in the U.S. economy.
The BIS 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 U.S. "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," the BIS said.
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.
The BIS dissected the current crisis into six stages from the beginning in about June of last year when financial institutions began reporting massive losses on subprime mortgage instruments. The crisis peaked in March and May, and with the U.S. Federal Reserve intervening to avert the collapse of investment firm Bear Stearns.
But even though 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 was at the moment extremely pronounced owing 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 crimp consumer spending.
In the short-term, the BIS said that governments must act to avert a risk of banks collapsing, by encouraging them to cut dividends and bonuses to increase capital cushions. And the private sector should be tapped for capital injections.
But in the long-term, the issue of cheap credit, at the heart of the crisis, had to be addressed. The BIS suggested that central banks keep interest rates on a vigilant stance even when inflation was not a threat.Copyright Agence France-Presse, 2008