BASEL, Switzerland, June 30 - The Bank for International Settlements (BIS) said on Monday the world economy was stuck in "an uncomfortable soft spot" with deflation and a weakening dollar new threats to an already stuttering recovery. To ensure a long-term recovery, Asia and Europe would have to start pulling their weight because the United States had been a "disproportionately large source of global demand growth" for almost a decade, it said. "To ensure the sustainability of a truly global expansion, more needs to be done to strengthen domestic demand growth in countries with healthy external balances," the Basel-based BIS said in its 73rd annual report. "In Asia, this implies allowing currency appreciation and eschewing export-led strategies for growth. In continental Europe...implementing the structural reforms that will allow the industrial sector to respond flexibly to a stronger euro." The year to end March had been marked by economic disappointments and there was no clear evidence of a decisive improvement in macro trends.
The BIS, a forum for the world's central banks, said economic prospects for the United States were uncertain, Europe's potential had weakened and Japan's outlook was mixed. Elsewhere in Asia, economies had been hurt by the spread of the SARS virus, but the outlook was brighter for other emerging markets in Latin America, central and eastern Europe and Africa. DEFLATION WORRIES Adding to the BIS's worries was the growing spectre of deflation. Japan and China, where falling prices are already a reality, would suffer even more if their currencies rose against the dollar, but "disinflationary forces were evident almost everywhere," the BIS said. "The quarterly frequency of effective deflation has jumped significantly," it said.
Deflation on its own was not necessarily a bad thing, but combined with sharp asset price falls, strong resistance to wage cuts, already low or non-existent interest rates and a high level of indebtedness, it posed a challenge for policymakers. "The difficulty at the present juncture is that many of the prior conditions needed for deflation to become a problem seem to be in place," it said. Policymakers' key dilemma was how to resolve imbalances in demand and external accounts while also achieving solid growth. Corporate investment, still low as firms focused on strengthening balance sheets, was crucial as consumer spending could weaken in an environment of rising debt, potentially weaker house prices and higher unemployment. The BIS said while a falling U.S. dollar was beneficial to the world's largest economy, the fact that U.S. expansion was financed by Europe and Japan would mean those regions would be particularly vulnerable should the currency continue to slip. "Should the dollar fall further...it is the creditors who would this time have to bear a double burden of adjustment," it said, warning especially Asian countries against intervening to cap domestic currency rises, which could inflate the euro. Europe, particularly Germany, is really hurting as the euro marches higher, hampering exports and stifling growth. The BIS applauded banks outside Japan for weathering the market downturn, but said continued economic woes could destabilise the financial system, with banks still exposed to weak telecom, technology and travel sectors.//