In the current environment, clear signs are now beginning to emerge that the recovery in the advanced economies is strengthening and that this is already positive for the region. While the pace of growth in the major industrial countries is still below their potential, it has been revised upwards to reflect improved consumption and business investment activity. Most encouraging has been the indicators of business investment, particularly IT investment, which has been stronger-than-expected. This has been supported by improved corporate cashflows and the low interest rates environment. In Japan, signs of recovery have emerged while in the euro area, indicators of business sentiment suggest a stabilisation from the current weakness. These developments augur well for growth in the region in the second half of this year and in 2004. Indeed, the positive performance of the global stock markets reflected an anticipation of stronger future growth. While these are encouraging trends for the region, we need to look beyond the prospects of the current cyclical recovery. Several significant imbalances however, still remain in the global economy. BIS Review 43/2003  1  An important issue that needs to be addressed is how the unbalanced growth that has taken place in the world economy can be resolved with orderly adjustments of both the economies concerned as well as of the respective financial markets. The adjustments need to take place while maintaining robust overall global growth. Global growth still remains dependent on the US as an important trading partner.
An additional element threatening the stability of the global financial system was that virtually all of the leveraged Treasury bond investors had similar positions, including major financial institutions. Banks’ direct exposures may be an important aspect of financial instability in periods of financial market volatility. In addition, banks may hold significant exposures with non-bank financial institutions, which themselves suffer from direct market exposures. The Barings crisis in 1995 is an example of the first case, while the LTCM case is an example of the second. In my view, the eventual scale of a systemic crisis might depend on the magnitude of the deviation of asset prices from fundamentals. How, then, do asset price bubbles get created in the first place? They may be created or exacerbated by some form of herding and overly buoyant investor expectations, as groups of investors imitate leading institutions’ strategies. Bubbles may be further boosted by a lack of adequate disclosure, problems of conflicts of interest, and destabilising trading or investment strategies. Once bubbles burst, portfolio insurance strategies in the event of falling prices - or dynamic hedging might heighten the downward spiral. Particularly in earlier episodes of equity-driven financial instability, such as the 1987 stock exchange crash, the initial wave of the sale of equity futures appears to have resulted in an accelerated decline in stock prices. However, the jury is still out on the role of tools such as portfolio insurance or automatic trading rules in exacerbating aggregate financial risk.