Bank Of International Settlements Report On Global Economy

Bank Of International Settlements Annual Report 

The Bank for International Settlements (BIS) is a unique institution that acts as the central bank for central banks and provides unparalleled insight into the global financial system.

Recently, the Bank of International Settlements (BIS) published its annual report (June 2024), a timely and relevant document that suggests impending changes in the global financial system, which may not be favourable.

The report opens with a cautiously optimistic note titled ‘So Far, So Good’, acknowledging the global economy’s resilience in the face of the pandemic, geopolitical conflicts, and political instability.

The introduction gives a brief overview of various macro factors and notes that monetary policy has been successful in taming inflation.

However, the BIS does stress that challenges remain.

The report then addresses three key areas:

The impact of current monetary policy

Their learnings from the last two decades

The role of Artificial Intelligence

The Impact Of Current Monetary Policy 

When distilled down, monetary policy involves adjusting interest rates; interest rates affect how much people can borrow.

Because the economy is debt-based, less borrowing means less economic growth and vice versa.

The Bank of International Settlements (BIS) start by reiterating that everyone expects a soft landing. That’s because interest rates rose without restricting borrowing too much.

While fiscal policy has helped, they warn that governments must restrict spending to bring inflation down.

This criticism of government spending is significant, given that central banks are supposed to be apolitical.

Structual Reform

The BIS goes one step further by calling on governments to engage in structural reform efforts. It specifies that these reforms should focus on a better distribution of income.

In essence, governments should reduce the wealth gap.

While this would, in theory, resolve the problem of income distribution, in practice, the rich will find loopholes to avoid paying their fair share.

Some argue that the best solution is to allow wages to rise and accept the inflation that will come as a part of that process.

That would improve income distribution but also hurt corporations’ bottom lines, which is why they have been trying to suppress wages through automation and migration.

In the report, the BIS notes that the economy has been surprisingly strong. They highlight that inflation has come down while unemployment has stayed low.

Note: Recent data suggests that might be changing.

They note that the pandemic marked the bottom of the decline in interest rates that began after the 2008 financial crisis. In addition, it could have marked the top for the size of central bank balance sheets as central banks buy government debt to stimulate the economy during times of crisis, also known as money printing.

They suggest that rising interest rates have done little damage to the economy because of the duration of the debt.

In simple terms, most individuals borrow money at a fixed interest rate for the long term. Short-term changes have no effect. Additionally, individuals and institutions with lots of cash can earn significant interest rates on their savings.

This has paradoxically resulted in a stimulus for the rich, further increasing wealth inequality. The average person is falling behind due to persistent inflation and higher interest rates, particularly in the U.K. and the E.U.

At the same time, it has made headline economic figures look good at first glance.

Energy Prices And Commodities

The BIS acknowledges rising energy prices are a factor but fails to note that these result from arguably counterproductive sanctions.

Sanctions raise energy prices, which benefit Russia. According to the IMF, Russia’s economy is growing faster than all developed economies.

The BIS claims that inflation continues to come down and confirms that this is mainly due to declining commodity prices. They also highlight that this disinflation is partially coming from China.

China’s economy is struggling, so it’s trying to export as much as possible to boost it. This is causing the price of many goods to fall sharply.

However, most foreigners aren’t buying these goods, even at discounted prices.

That does suggest that the global economy is fragile.

The BIS provides insight into how central banks contributed to the surge in inflation after the pandemic. In short, the central banks waited a year to raise interest rates to combat the spiralling inflation, which allowed inflation to go higher than it otherwise would have.

Potential Challenges Outlined By The Bank of International Settlements

The BIS concludes this part of the report with a comprehensive analysis of the potential challenges that the global economy could face and the scenarios that could unfold.

The first problem is inflation. It could rise again because of goods, wages or commodities.

The second problem is the levels of government debt, specifically the debt levels that have made fiscal and monetary policy challenging.

In short, fiscal and monetary policy will increase debt, while fiscal and monetary restrictions will make it difficult to pay it down.

They state that it takes two to three years for the effects of the first rate hike to be felt in the financial markets. That is in contrast to FED J Powell, who stated that the effects were instant due to investors pricing everything in.

If the BIS is correct, then the great hiking cycle is still in its early stages, and the real lag effect will be felt over the next year unless central banks start cutting.

The BIS suggest it could already be too late, as China’s slowing economy could drag the rest of the world down.

Note: The Bank of Japan’s recent decision to raise interest rates may have been based on a ‘collective’ agreement between China, the U.S., and Japan to weaken the U.S. dollar.

This next problem outlined by the BIS is a decline in productivity.

GDP per capita is declining in many Western countries, particularly Canada.

Given these risks, the BIS envisions two potential scenarios that could disrupt the global economy.

The first is a resurgence in inflation, and the second is a hard landing or, more specifically, a recession. A recession would not only significantly impact the global economy, but it could also have long-lasting effects that would need to be carefully managed.

Bank Of International Settlements Learnings 

The second part of the report is also about monetary policy. However, the focus is on the future rather than the past.

Central banks have accumulated a wealth of knowledge over the last two decades, learning five key lessons that have significantly shaped their policies and actions.

First, they learnt that responding to inflation quickly by raising rates aggressively can bring it down.

Secondly, they’ve learnt that they can print money to prevent the economy from collapsing.

That links to the third learning, which is that there are limits to how effective money printing is in stimulating the economy. Each round needs to be bigger than the last for stimulus to increase economic growth.

The BIS confirms this, and the report reveals that this effect is most pronounced when there is no economic stress.

They point to the negative interest rates in Europe and elsewhere as proof all this stimulus did was inflate asset prices. It didn’t stimulate the economy.

The fourth thing that central banks have learnt is that ‘communication has become more complicated’.

In practical terms, central banks have become more involved in the everyday lives of the average person.

The practical effect of central banks taking centre stage is that everyone is hanging on to their every word and increasingly scrutinising their actions or inaction.

This makes central banks more political, increasing the risk that they could once again become an arm of government.

Note: The BIS has warned in its research papers that if central banks become too politicised, this would result in hyperinflation, as the average person would vote for the central bank to print money to give to them. (Who could blame them? The rich have been doing it for decades).

Forex Intervention

The fifth thing that central banks have learnt is that FOREX intervention can enhance financial stability.

FOREX intervention involves one central bank printing its currency and swapping it for another currency with another central bank.

A Foreign central bank can use the U.S. dollar to buy and stabilise its own currency. The most notable example of this has been the Bank Of Japan. The BOJ has been buying Yen with USD swaps to prevent the Yen from completely collapsing. It’s assumed that the swap will never be paid back.

This gives the largest central bank, in this case, the Federal Reserve, incredible geopolitical power, as it can influence the value of other currencies through its currency swaps and interventions.

Theoretically, if the Chinese Yuan collapses and the PBOC asks for a dollar swap, the FED could reject the request, forcing the Yuan to devalue.

This would never happen in practice because if the FED rejected the swap request, the PBOC would start selling U.S. government debt (U.S. bonds) for U.S. dollars. As bond prices are inversely correlated to yields, this would cause U.S. bond yields to rise, which in turn would cause rates to spike.

In effect, FOREX swaps reduce the need for central banks to sell their holdings of foreign bonds to support their currencies. This, in turn, reduces the risk that global bond yields and interest rates will rise, reducing market volatility.

Potential Risks Identified By The Bank of International Settlements

The BIS concludes this section of the report with a comprehensive analysis of the potential challenges and risks that could potentially confront central banks in the foreseeable future, underscoring the need for caution and preparedness.

They touch on the headwinds caused by de-globalisation and demographics.

The BIS urges central banks to exercise ‘realism’ and not rock the boat with significant monetary policy changes.

Finally, the BIS urges governments to stop excessive spending. They boldly claim that constant money printing by governments and central banks may not be necessary to drive economic growth.

The Role Of Artificial Intelligence 

The third part of the report outlines their perspective on Artificial Intelligence.

From the BIS’s perspective, artificial intelligence will affect central banks, hence the dedicated section in the report.

The BIS states:

‘LLMs suffer from the hallucination problem: they can present a factually incorrect answer as if it were correct and even invent secondary sources to back up their fake claims. Unfortunately, hallucinations are a feature rather than a bug in these models. LLMs hallucinate because they are trained to predict the statistically plausible word based on some input. But they cannot distinguish what is linguistically probable from what is factually correct.’

That is a quote to remember.

They note that large language models (LLMs) are becoming increasingly advanced, allowing for the generation of video, audio, image, and text.

In addition, they note that this has led to a debate about whether to refer to these LLMs as AI. They suggest that they should be referred to as artificial general intelligence (AGI).

However, what matters is what these tools can do and how they affect things.

AI And The Financial System

They believe AI will ‘affect financial systems as well as productivity, consumption, investment and labour markets which have direct effects on price and financial stability’.

They reveal that central banks plan to use AI in their operations.

In addition, they note that even if central banks don’t use AI, they must be ‘observers of the technology and how it could affect their mandates’.

The BIS then explains how AI could affect the financial system, discussing everything from lowering costs to optimising payments.

They suggest using AI in ‘high-risk, low-margin activities’ like inter-bank transfers, Know Your Customer (KYC), and/or anti-money laundering (AML).

The BIS expands on using AI to assess creditworthiness and notes that associated checks ‘can also be of a non-financial nature’, such as an applicant’s educational history or online shopping habits.

They suggest it can be used for insurance, too.

The BIS even addressed the genuine bias and discrimination risks such AI tools would have.

They point to the fact that these AI tools would collect a lot of sensitive data and that most of them would likely be developed by a handful of big tech companies.

They believe that AI being controlled by a handful of entities is inevitable.

The BIS then looks at how the central banks can leverage AI.

They note that AI could be used to help collect and analyse data related to their mandates.

Projects

They reveal that the BIS is already working on project Aurora, which analyses transactions for money laundering.

A further project called Agora involves tokenising assets on blockchains owned and operated by central banks.

Once everything is centrally monitored and controlled, the BIS says it will be possible for central banks to do ‘now casting,’ which is to adjust their monetary policies in real-time in response to real-time changes.

That possibility becomes more likely if the central banks combine AI developments with a central bank digital currency (CBDC).

The Bank Of International Settlements View On AI And The Economy

The BIS end the report with a lengthy analysis of how AI could impact the economy and how central banks should prepare.

They start by predicting that AI will help boost global productivity, which central banks need to keep interest rates high.

The BIS firmly believes that AI will not decrease but rather increase the demand for labour, a reassuring perspective for those concerned about the future of employment in an AI-driven world.

The BIS sees AI’s potential to make more people productive, regardless of their skill level, as a democratisation of productivity, offering hope for the future of work.

In their view, the trade-off is that AI could increase economic inequality if it continues to be controlled by a handful of big tech companies owned by an even smaller handful of tech entrepreneurs and asset managers. This raises concerns about its societal implications, particularly in terms of wealth distribution and access to opportunities.

The BIS notes that there’s a real risk that governments will have to turn the money printer back on to support the average person if AI starts to take their jobs.

Regarding how central banks should prepare, the BIS advises them to focus on developing in-house AI tools rather than leveraging third-party products.

What It Means For Investors And The Markets 

The key takeaway from the report is that debt and inflation are genuine risks. Both could create severe market volatility.

In the case of debt, too much debt could raise long-term interest rates as the supply of bonds increases too much relative to demand, causing bond prices to fall and yields to rise.

Uncertainty around fiscal policy could also create bond market volatility.

Government bonds are considered to be the safest financial assets. As a result, they are often used as collateral for loans. In effect, debt is being used as collateral for yet more debt.

Government bonds are considered safe because governments can always tax their citizens to pay their creditors.

However, suppose the value of these bonds suddenly experiences volatility due to, for example, poor fiscal policy. In that case, those who borrowed against these bonds risk being liquidated, i.e., forced to sell.

This potential scenario of forced selling across the board should raise serious concerns about the potential consequences of excessive debt and inflation. It underscores the urgent need for careful management of these economic factors.

Similarly, in the case of too much inflation, holders of government bonds will demand a yield to compensate for the fact that when the bond is paid back, the money won’t be worth what it was when they lent it out because of inflation.

This can cause rates to rise and could cause bond volatility.

Aside from economic growth driven by a parabolic increase in productivity, the only solution to this problem is what macro analysts call debt monetisation, which is essentially the process of a government borrowing money from the central bank to finance its spending (money printing).

Central banks will have to buy up the excess government debt to ensure that yields stay down and markets stay calm.

That will be rocket fuel for risk assets as they are the most liquidity-sensitive.

What does it mean for the investor?

It’s a double-edged sword.

On one edge, interest rates and inflation will likely remain elevated for the average person.

On the other hand, this will create extreme social pressures that result in political change—hopefully for the better.

For the rest of this decade, we will see more of the increasing political and geopolitical instability in recent years.

Asset prices will keep rising because of central bank money printing.

We are at the peak of globalisation, wealth concentration, financialisation, and geopolitical and political instability.

Most countries seem to be shifting to a form of economic nationalism.

In the short term, this will be painful because asset prices will stay high while the prices of goods rise as a result of workers finally being paid their fair share. However, asset prices will cool off in the longer term, and wages will continue growing.

Buying a house and starting a family in the next decade will become more affordable.

As important, how hard you work will finally be reflected in your pay cheque, which will supercharge economic productivity.

In economic terms, power will shift from capital to labour.

That will facilitate a new generational cycle of genuine growth, prosperity and equality.

Tin Foil Hat

Finally, and on an AI note, the (sinister) implications of the likely developments in banking need to be watched closely.

AI could also be used to assess whether someone is creditworthy. Combining this with AI’s evident biases and a (Chinese) Social Credit System leads to a potentially scary scenario:

People who act or think in the ‘wrong way’ don’t get a loan etc.

Combining Project Aurora, Project Agora, and a central bank Digital Currency (CBDC) could lead to an AI-driven financial dystopia. One in which you will own nothing. The AI will own it all.

That may be an exaggeration, but it’s not far from what the BIS describe.

This potential future underscores the need for caution and ethical considerations in the development and implementation of AI in the financial sector.

Click on the link below to read the full Bank of International Settlements report.

Link:   Bank of International Settlements Annual Economic Report

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