The "borrowed time" that central banks have created for developed countries' governments to push through with reforms is nearing the end, but emerging markets are the ones likely to suffer most if the end of easy money comes abruptly, Jaime Caruana, general manager of the Bank for International Settlements, said.
"Central banks have borrowed the time that the private and public sectors need for adjustment, but they cannot substitute for it," Caruana said in a speech at the BIS's annual meeting in Basel at the weekend.
Sustaining the stimulus increases the challenges faced by central banks when trying to normalize monetary policy, magnifies the risks to financial stability, worsens the misallocation of capital and exposes open economies to spillovers, according to the BIS.
"The challenges are particularly severe for the emerging market economies and smaller advanced economies where credit and property prices have been rapidly growing," Caruana said.
Strong capital inflows "expose economies to large sudden reversals if markets expect an exit from unconventional policies, as volatility during the past few weeks seems to indicate," he added.
The yields of certain emerging market bonds, which had fallen to record lows over the past two years, jumped more than those of periphery eurozone debt last week, when Federal Reserve Chairman Ben Bernanke seemed to confirm that the Fed would start cutting down on its asset purchases in the autumn.
The BIS general manager said that "the balance of costs and benefits entailed by continued monetary easing has been deteriorating" and that the borrowed time should be used to end the dependence on debt, strengthen productivity growth by making economies more flexible, completing regulatory reform and "recognizing the limits of what central banks can and should do."
DELEVERAGING
He noted that many big companies took advantage of low rates to use cheap funding to increase the maturity of their existing debt, rather than to invest in new production capacity.
"It does not matter how attractive the authorities make it to lend and borrow – households and firms focused on balance sheet repair will not add to their debt, nor should they," Caruana said. "And, most of all, more stimulus cannot revive productivity growth or remove the impediments that block a worker from shifting into a promising sector," he added.
Governments that currently have the lowest funding costs have the biggest need for fiscal adjustment, according to BIS data.
The US and the UK, when taking into account the increase in spending for health care and pensions, would need to improve their primary fiscal balance by more than 10 percentage points to cut public debt to 60% of GDP by 2040, the BIS has calculated.
"These are huge adjustments," Caruana said. "And the numbers for many other advanced economies are not much smaller."
He called for cuts on spending, especially in government consumption and transfers, rather than for tax increases to improve public finances, for reforms to strengthen the growth of productivity and for the completion of reform in the financial sector, including the European Union's banking union.
Caruana stressed that he was not calling for "undifferentiated, simultaneous and comprehensive tightening of all policies" but rather for measures that are tailored to the needs and circumstances of each country.
"Monetary policy has done its part," he said. "Recovery now calls for a different policy mix – with more emphasis on strengthening economic flexibility and dynamism and stabilizing public finances."
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