By Andrew Bailey, Governor of the Bank of England.
It can sometimes be challenging when the economy is exposed to big external shocks – and we have been experiencing, and sadly continue to do so, some very big ones of late – but there are very substantial and continuous benefits from free trade, investment and open markets both in goods and in financial services.
That said, we have to recognise that today we live in a world economy which is experiencing fragmentation, and that is at risk of further such pressure.
The World Trade Organisation has recently reported that the share of so-called intermediate goods in world trade – these are the goods that form inputs to the final product – fell to 48.5% in the first half of this year, compared to an average of 51% in the previous 3 years. This is an indicator of pressure on global supply chains.
COVID was an important first shock to the supply chain system, and I will include in this the disruption to global supply chains that we saw in the early part of the recovery from the severe initial impact of COVID on the world economy. It means that extended just-in-time supply chains have moved from being a perceived source of strength to a perceived vulnerability, hence the reduction in the share of trade accounted for by intermediate goods.
This is not, however, the end of the story on fragmentation in the world economy.
Russia’s illegal and utterly reprehensible invasion and war on Ukraine has been a further source of economic disruption and fragmentation – notably in energy and food supplies – which has seriously disrupted supply chains and economic conditions.
Let me also add a comment which relates to events nearer to home. As a public official I take no position on Brexit per se. That was a decision for the people of the UK. It has led to a reduction in the openness of the UK economy, though over time new trading relationships around the world should, and I expect will, be established. Of course, that requires a commitment to openness and free trade.
To sum up this part of the story: we have moved from a state of affairs where the orthodoxy was to open up the world economy, to increase trade flows, and increase the flows of finance to support this trade. In doing so, yes there was an increase in interlinkages and dependencies around the world economy. Some of those interlinkages turned out to be less resilient than we had expected.
We can’t ignore that for the sake of free trade idealism, because the threats that are behind it are sadly real. But, nor must we give up on openness. Diversifying supply chains to increase resilience does not need to involve protectionism.
Just as reducing openness does the same thing to economic growth, so fragmentation damages financial markets. But it doesn’t just reduce the size of markets, it makes them inherently less stable. Fragmentation is a risk to financial stability.
Put simply, large markets and their infrastructures, which are run safely and to high standards, will support rather than endanger financial stability. A very good example of this is clearing and central counterparties. Fragmenting this type of market infrastructure creates rather than reduces risks in markets. It also increases the cost of market functioning.
Underpinning the extensive co-operation and co-ordination are international regulatory standards. They provide a core of assurance to support open financial systems. To be honest, some areas are ahead of others. The Basel Committee has made most progress, though it is essential that we see a consistent implementation of the so-called Basel 3.1 package.
We have more to do in the various parts of the non-bank world, and the Financial Stability Board is very much on the case.
But this does not mean that in all jurisdictions the rules must be exactly the same. We are most interested in the outcomes. There will be differences to fit local markets, and again when that is done in a transparent and well understood way, it is sensible and fine. All of that fits within a framework of public policy where the basic objective of financial stability is common, and there should be effective frameworks established through international regulatory standards underpinned by trust and co-operation.
To conclude, we must be alert to the pressure for fragmentation, both in the global economy and financial system. The costs that go with such fragmentation are real and undesirable. The better approach is strong articulation of a common public policy objective in terms of financial stability, accompanied by effective co-ordination and
co-operation. These are not impossible ideals – we have real evidence of the system working.
The above are extracts from a speech given by Bailey at the Central Bank of Ireland Financial Systems Conference