Heavily indebted countries can look just fine until suddenly they don’t, finance watchdog warns—’That is how markets work’

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Indebted countries are vulnerable to a precipitous loss of confidence even though that risk is barely acknowledged in bond markets, the Bank for International Settlements warned. 

The Basel-based institution said in its annual economic report released on Sunday that countries whose bloated fiscal positions are further stretched by higher interest rates should prioritize fiscal repair. Claudio Borio, head of the BIS’s monetary and economic department, said they must act “with urgency.”

“We know from experience that things look sustainable until suddenly they no longer do,” he told reporters. “That is how markets work.”

While the need to fix public finances has been a recurring theme for the BIS, the remarks coincide with heightened scrutiny on indebted economies. Worries about France this month prompted investors to demand the highest premium on its bonds since 2012. 

The Basel officials didn’t specify any country in particular, but they did feature a chart looking at the debt and market pricing of some of the world’s biggest borrowers, including Japan, Italy, the US, France, Spain and the UK.

In order to stabilize finances, advanced economies can this year run deficits no larger than 1% of gross domestic product, down from 1.6% last year, the BIS said. That’s a fraction of the current US deficit, which the International Monetary Fund described last week as “much too large.”

“Though financial market pricing points to only a small likelihood of public finance stress at present, confidence could quickly crumble if economic momentum weakens and an urgent need for public spending arises on both structural and cyclical fronts,” the BIS said. “Government bond markets would be hit first, but the strains could spread more broadly.”

Inflation is subsiding however, BIS officials acknowledge. The world is currently set for a “smooth landing,” General Manager Agustin Carstens said.

Services still pose a risk to that outlook, with prices in that area out of step with pre-pandemic trends, the report said. In addition, increases in the cost of commodities due to geopolitical tensions could reignite inflation. 

Given these pressure points, officials highlighted that central banks should be cautious about cutting rates too soon. That could prove costly to their reputations if such policy needs to be reversed amid a flare-up of inflation again, the report said. 

Policymakers already did their fair share to contribute to that problem, the BIS suggested, repeating its accusation that “with the benefit of hindsight,” pandemic-era stimulus probably raised the risks of second-round effects.

While central banks shouldn’t ease too soon, governments also have a part to play with too-loose fiscal policy, officials said. Instead, they should widen tax bases and deliver structural reforms to meet future challenges including demographic shifts and climate change.

“Our main message is that central banks alone cannot deliver a durable increase in economic growth and prosperity,” Borio said. “Laying the foundation for a brighter economic future also requires actions from other policymakers, especially governments.”

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