'Central banks must weigh stimulus exit to avoid side effects'

Written by Reuters | Switzerland | Updated: Jun 30 2010, 04:09am hrs
Governments must slash budget deficits decisively and central banks should not wait too long to raise borrowing costs as side effects from measures prescribed to tackle the global recession may create the next crisis, the Bank for International Settlements said.

The global economy as well as financial markets were on the mend, though the recovery remained fragile in the advanced economies and in the euro zone the debt crisis put the recovery at risk, the BIS said in its annual report, published on Monday.

Global leaders meeting in Toronto agreed to take different paths for shrinking budget deficits and making banking systems safer and Washington in particular has warned against cutting too fast. But the head of the BIS said there was no time to waste. We cannot wait for the resumption of strong growth to begin the process of policy correction, BIS general manager Jaime Caruana told the banks annual general meeting.

In particular, delaying fiscal policy adjustment would only risk renewed financial volatility, market disruptions and funding stress. The BIS, which acts as a bank to central banks and a discussion platform for policymakers, said reforms of the financial system remained key to prevent further crises. Top central bankers met at the BIS annual meeting from June 26-28 in Basel, following the G-20 summit where leaders acknowledged the uneven and fragile economic recovery in many countries.

In a reversal from the unity of the past three crisis-era Group of 20 summits, the leaders left room to move at their own pace and adopt differentiated and tailored policies. But the BIS warned powerful support measures had strong side effects and said their dangers were starting to emerge.

To put it bluntly, the combination of remaining vulnerabilities in the financial system and the side effects of such a long period of intensive care threaten to send the patient into relapse, the BIS report said. It said if the extraordinary measures were kept in place for too long, policymakers ran the risk of creating zombie banks or companies, dependent on direct support.