Governments must slash budget deficits decisively and central banks should not wait too long to raise borrowing costs as side effects from the medicines prescribed against 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.

Massive government spending together with extraordinary measures from central banks had helped to avoid another Great Depression and many markets were working again, the report said.

But such powerful measures have strong side effects, and their dangers are beginning to become apparent, the BIS said.

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, 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 G20 summit in Toronto, where global leaders agreed to take different paths for cutting budget deficits and making their banking systems safer, a reflection of 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.

FINE LINE

The BIS acknowledged the tricky situation for policymakers as the stakes were high and the risks from capping lifelines too early loomed large.

Central banks especially were walking a fine line.

The banking system was still far from sound, as recent profits from fixed income and currency trading and the low interest rate environment were hard to repeat and not all crisis-related losses may have been booked.

But the longer that policy rates in the major advanced economies remain low, the larger will be the distortions they create, both domestically and internationally, the BIS said.

Extremely low real or inflation-adjusted rates altered investment decisions, postponed the recognition of losses, increased risk-taking in the search for yield and encouraged high levels of borrowing, the BIS warned.

In addition, central bankers may underestimate inflation risks as the crisis may have lowered potential growth rate.

Should the extraordinary measures be kept in place for too long, policymakers ran the risk of creating zombie banks or companies, dependent on direct support, the BIS said.

Markets have pushed back expectations for rate increases in the United States in the euro zone in the wake of the Greek debt crisis.

UNSUSTAINABLE DEBT

Challenges for emerging economies were different as they were recovering strongly and inflation was picking up, the BIS said.

Some EMEs could rely more on exchange rate flexibility and on monetary policy tightening, the BIS said.

The Greek debt crisis had highlighted that many governments had to immediately consolidate their finances as highly indebted countries would not be able to rescue banks as a buyer of last resort in another crisis.

The importance of consolidation was underscored in May, when the austerity measures announced by the governments of Greece, Portugal and Spain met with a lukewarm response in markets, the BIS said.

In contrast, Ireland kept its debt spreads stable in 2009 and early 2010 despite projected deficits at the level of Greece.

For the full report, click on the BIS website: www.bis.org

(Reporting by Sven Egenter; Edited by Toby Chopra)

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